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FM Notes:

Contents
Chapter-7: Risk & Return ........................................................................................................ 3
Relation between Risk and return ........................................................................................ 3
How to measure risk ........................................................................................................... 3
How Diversification Reduces Risk ....................................................................................... 4
Types of Risks and how it works: .......................................................................................... 4
Efficient Portfolio ................................................................................................................ 6
Let’s introduce Risk-free rate in Portfolio (Two steps separation theorem): ............................ 6
Sharpe-Ratio & Capital Market Line ..................................................................................... 7
Chapter 8: Capital Asset Pricing Model ................................................................................... 8
Beta β ................................................................................................................................ 8
Unlevered Beta and Levered Beta ........................................................................................ 8
Portfolio Betas .................................................................................................................... 9
The capital asset pricing model (CAPM): .............................................................................. 9
Security Market Line ........................................................................................................... 9
Arbitrage Pricing Theory (APT)............................................................................................ 10
Chapter-9: Cost of Capital .................................................................................................... 11
Cost of Long-Term Debt .................................................................................................... 11
Calculating Cost of Debt ................................................................................................... 11
Cost of Preferred Stock ..................................................................................................... 12
Cost of common stock...................................................................................................... 13
Cost of retained earnings. ................................................................................................. 14
Cost of new issues of common stock ................................................................................ 14
Calculating the Weighted Average Cost of Capital (WACC) ................................................. 15
Chapter 16 Does Debt Policy Matter ..................................................................................... 15
Modigliani and Miller Proposition I: Irrelevance of Capital Structure .................................... 15
Modigliani and Miller Proposition II: The Impact of Taxes .................................................... 16
Chapter-13 Leverage and Capital Structure ........................................................................... 17
Operating Leverage ........................................................................................................... 17
Financial Leverage ............................................................................................................ 17
Combined Leverage.......................................................................................................... 17
Break-even Analysis ......................................................................................................... 18
Value of Firm .................................................................................................................... 18
Chapter-14 Dividend Policy................................................................................................... 20

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Firms pay Dividend by ....................................................................................................... 20

Mechanics of a dividend ................................................................................................... 20
How should stock prices behave? ..................................................................................... 21
Stock Buybacks ................................................................................................................ 21
Dividend vs Buybacks ....................................................................................................... 22

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Chapter-7: Risk & Return

Relation between Risk and return
Returns are generally associated with higher risk. This relationship is based on the idea
that investors require compensation for taking on risk.

[(ending value − initial value) + cash distribution]

Return =
initial value

Real Return= (1+Nominal Return)/(1+inflation rate)-1

Example Pearson Book:

Year Beginning Price End Price Dividend Return

2010 35 36.5 3.5 14.3% =((C2-B2)+D2)/B2
2011 36.5 34.5 3.5 4.1% =((C3-B3)+D3)/B3
2012 34.5 35 4 13.0% =((C4-B4)+D4)/B4

Expected Return 10.5% =AVERAGE(E2:E4)

Risk 5.6% =STDEV.S(E2:E4)
CV 0.53 =C7/C6

Other Formulas

• Expected Return (𝑟̅ ) = ∑(𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 ∗ 𝑟)

• Market Premium= Expected Return (𝑟̅ )- Risk-free return, rf

How to measure risk

With help of historical data, we can create a histogram which can be help understand
risk associated.

Overall Level of distribution is calculated by average or expected value (𝑟̅ ). While spread
of distribution is calculated by variance or Standard Deviation.

• Variance 𝑟̃ I = Expected value of (𝑟̃ I - 𝑟̅ )2

𝑛
1
𝑠2 = ∑(𝑥𝑖 − 𝑥ˉ)2
𝑛−1
𝑖=1
• Standard Deviation = Sqrt (𝑟̃ I)
More SD then more riskier. We want low risk and high return. Excel formula: STDEV.S

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The coefficient of variation (CV)—another risk indicator—is the standard deviation on an

asset’s returns divided by its average return. In other words, rather than measuring risk
solely by the volatility of an asset’s returns, CV shows the volatility of returns relative to
average or expected return.


CV = (Higher means more volatile)
r
There are two types of investors:
1. Risk Averse: Minimum Risk Taker
2. Risk Tolerant: High Risk Taker
Book Example with probability:

Head+Head 40%
Head+Tail 10%
Tail+Head 10%
Tail+Tail 20%

How Diversification Reduces Risk

Diversification is an investment strategy that involves spreading investments across
various assets to reduce the impact of any single asset's performance on the overall
portfolio. It's the classic "don't put all your eggs in one basket" principle.
Types of Risks and how it works:
• Reduces Unsystematic Risk: This is the risk specific to an individual investment
(like a company going bankrupt). By diversifying, the impact of one poor-
performing investment is lessened by the performance of others.
• Doesn't Eliminate Systematic Risk: This is the overall market risk, which
affects all investments. Diversification can't eliminate it, but it can help manage
its impact.

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𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑅𝑒𝑡𝑢𝑟𝑛 = ∑(𝑤𝑗 × 𝑟𝑗 )

𝑗=1

𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜌12 𝜎1 𝜎2

ρ_12=Corelation coefficient , 𝜎 = 𝑆𝐷
One more formula in terms of N:
1 1
𝑁 × ( )2 × 𝐴𝑣𝑔 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 + (𝑁 2 − 𝑁) × ( )2 × 𝐴𝑣𝑔. 𝑐𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒
𝑁 𝑁
Correlation measures the strength and direction of the linear relationship between two
variables. It ranges from -1 to 1.

• -1: Perfect negative correlation (variables move in opposite directions)

• 0: No correlation (variables are independent)
• 1: Perfect positive correlation (variables move in the same direction)
Covariance is related to correlation:

• Covariance = Correlation * SD of Asset A * SD of Asset B

• Corelation increases, Portfolio variance increases.

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In portfolio with N number of stocks then Variance is N and Covariance is N2-N

Efficient Portfolio
An efficient portfolio is one that provides the highest expected return for a given level of
risk, or equivalently, the lowest risk for a given expected return.
Efficient Frontier: The curve representing all possible portfolios that offer the highest
expected return for a given level of risk.
Let’s introduce Risk-free rate in Portfolio (Two steps separation theorem):
First step to select best portfolio with highest Sharpe-ratio and second step is to add
risk free asset by borrowing or lending as per risk appetite.
Impact of Borrowing at the Risk-Free Rate (-)
You borrow money and reinvest in portfolio
R=(2*expected return from portfolio A)-(1*interest rate)

• Leverage: By borrowing at the risk-free rate, investors can amplify their exposure
to risky assets. This can increase both potential returns and risk.
• Portfolio Optimization: It allows for creating portfolios with expected returns
beyond the efficient frontier, which is the set of portfolios offering the highest
expected return for a given level of risk.
• Increased Risk: While borrowing can enhance returns, it also increases the
downside potential.
Impact of Lending at the Risk-Free Rate (+)
You brought T-Bill and also invested in portfolio.
R=(1/2*expected return from portfolio A)+ (1/2*interest rate)

• Risk Reduction: Investing a portion of the portfolio in a risk-free asset reduces

overall portfolio risk.
Risk-free rate create a straight line.

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Let’s assume portfolio as market portfolio, where weight corresponds to the fraction of
overall market. So, in this all-unsystematic risk are diversified and remaining is
systematic risk which is market risk.

Sharpe-Ratio & Capital Market Line

Sharpe-Ratio: Slope of line which shows how much expected return rises when your risk
is increased by 1%.
Sharpe-Ratio= Risk-premium/Standard deviation

Sharpe-Ratio= (rM-rf)/ 𝜎M

Equation of Capital Market Line

𝑟𝑚 − 𝑟𝑓
𝑟𝑝 = 𝑟𝑓 + × 𝜎𝑝
𝜎𝑀

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Chapter 8: Capital Asset Pricing Model

Beta β
Beta measures the systematic risk of a specific asset or portfolio; it is an index of the
co-movement of an asset’s return with the market return.
β = Covariance Between Market & Portfolio/ Variance of Market
𝜎𝑖𝑀
𝛽𝑖 =
𝜎𝑀2
Portfolio Risk=𝛽𝑖 × 𝜎𝑀
Beta measures the slope of best fit line, while R square measures goodness of fit of the
best fit line.
Run Regression Analysis:

• Go to "Data" -> "Data Analysis" (if it's not visible, make sure you've enabled the
Data Analysis ToolPak).
• Select "Regression" and click "OK".
• In the "Input Y Range" box, enter the range of stock returns (e.g., A2:A101).
• In the "Input X Range" box, enter the range of market returns (e.g., B2:B101).
• Check the "Labels" box if your data has headers.
• Choose an output range or select a new worksheet for the results.
• Click "OK".
• Interpret Results:
• The regression output will include a table of coefficients. The coefficient
corresponding to the "X Variable" (market returns) is the beta.

Unlevered Beta and Levered Beta

Unlevered Beta (βu)

• Represents the systematic risk of a company's assets, assuming it has no debt.

• It is a measure of the company's business risk.
Formula:

βu = βe / (1 + (1 - Tc) * (D/E))

Where:

• βu = Unlevered beta
• βe = Levered beta (beta of the company's equity)
• Tc = Corporate tax rate
• D/E = Debt-to-equity ratio
Levered Beta (βe)

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• Represents the systematic risk of a company's equity, considering its debt level.
• It reflects both business risk and financial risk.
Formula:

βe = βu * (1 + (1 - Tc) * (D/E))

Relationship between Unlevered and Levered Beta:

• As the debt-to-equity ratio increases, the levered beta also increases.

• This is because debt amplifies the company's systematic risk.
Key Points:

• Unlevered beta is used to assess the underlying business risk of a company, independent
of its capital structure.
• Levered beta is used to evaluate the overall risk of the company's equity, considering both
business risk and financial risk.
• The relationship between unlevered and levered beta is influenced by the corporate tax
rate and the debt-to-equity ratio.
• CAPM uses levered Beta

Portfolio Betas
n
 p = ( w1  1 ) + ( w2   2 ) + ... + ( wn   n ) =  w j   j (8.7)
j =1

The capital asset pricing model (CAPM):

rj = RF + βj X (rm - RF)

Security Market Line

The Security Market Line (SML) is a graphical representation of the Capital Asset Pricing
Model (CAPM). It depicts the relationship between the expected return of an investment
and its systematic risk (beta).

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Stocks above or below SML will eventually meet it because of following reasons:

• Market Efficiency: In an efficient market, mispricings are quickly corrected as

investors identify opportunities and trade accordingly.
• Arbitrage: Profit-seeking investors exploit mispricings by buying undervalued
securities and shorting overvalued ones, driving prices back to the SML.

Arbitrage Pricing Theory (APT)

Key Concepts

• Multiple Factors: APT assumes that multiple factors, such as interest rates,
inflation, industrial production, and oil prices, can influence asset returns.
• Factor Exposures: Each asset has a sensitivity to these factors, measured by
factor loadings or sensitivities.
• Risk Premium: Each factor has a corresponding risk premium, which is the
expected excess return for bearing exposure to that factor.
• Expected Return: The expected return of an asset is calculated as the risk-free
rate plus the sum of the product of each factor's risk premium and the asset's
sensitivity to that factor.
APT Model
The APT model can be expressed as follows:
Expected Return = Risk-Free Rate + (Factor Loading 1 * Factor Risk Premium 1) + (Factor
Loading 2 * Factor Risk Premium 2) + ...

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Chapter-9: Cost of Capital

Four Basic sources of long-term debt are:
1. Long-term Debt
2. Preferred Stock
3. Common Stock
4. Retained Earnings
Cost of Long-Term Debt
The cost of debt represents the interest rate a company pays on its debt obligations.
Key Points
• Pre-tax cost of debt: This is the interest rate a company pays on its debt before
considering the tax benefits.
• Flotation costs are the expenses incurred by a company when issuing new
securities. These costs include underwriting fees, legal fees, and registration fees.
They reduce the net proceeds a company receives from issuing securities.
• After-tax cost of debt: This is the interest rate a company pays on its debt after
considering the tax benefits. Since interest is typically tax-deductible, the after-tax
cost of debt is lower than the pre-tax cost.

Perpetual debt is a type of debt security that has no maturity date. Unlike traditional
bonds, which have a fixed maturity date, perpetual debt continues to pay interest
indefinitely. This makes it like preferred stock in some respects.

The value of a perpetual debt security is calculated using the following formula:
Value of Perpetual Debt = Annual Interest Payment / Required Rate of Return

Where:
• Annual Interest Payment: The amount of interest paid annually on the debt.
• Required Rate of Return: The rate of return that investors demand for holding
the perpetual debt.

Calculating Cost of Debt

The most common method to estimate the cost of debt is by using the yield to maturity
(YTM) of a company's outstanding bonds.
Formula: After-tax cost of debt = Pre-tax cost of debt * (1 - Tax rate)
Steps:
1. Determine the market price of the company's bonds.
2. Calculate the yield to maturity (YTM) of the bonds, which represents the pre-
tax cost of debt.
3. Adjust the YTM for taxes to find the after-tax cost of debt.
______________________________________________________

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Problem
A company issues a bond with a face value of $1000, a coupon rate of 8% (paid
annually), a maturity of 5 years, and a current market price of $950. The company's tax
rate is 35%. Calculate the after-tax cost of debt.
Solution
Step 1: Calculate Yield to Maturity (YTM)
• We can use financial calculators or spreadsheet functions like Excel's RATE
function to calculate the YTM.
• Given:
○ Face value = $1000
○ Coupon rate = 8% (annual coupon payment = $80)
○ Market price (PV) = $950
○ Maturity = 5 years
• If floatation cost, then (% of Face value) and deduct from (PV) which will be net
proceed (new PV).
• Using Excel's RATE function:
○ =RATE(nper, pmt, pv, fv, type)
○ =RATE(5, 80, -950, 1000, 0)
○ This will give you the YTM, which is the pre-tax cost of debt.

Step 2: Calculate After-Tax Cost of Debt

● After-tax cost of debt = Pre-tax cost of debt * (1 - Tax rate)
For example, if the calculated YTM is 9% and the tax rate is 35%, then:
● After-tax cost of debt = 9% * (1 - 0.35) = 5.85%
Therefore, the after-tax cost of debt for the company is 5.85%.

Cost of Preferred Stock

The cost of preferred stock represents the rate of return required by preferred
shareholders.
Calculation of Cost of Preferred Stock

The formula to calculate the cost of preferred stock (Rp) is:

Rp = Dividend per share / Market price per share

Where:
● Rp = Cost of preferred stock
● Dividend per share = Annual dividend paid to preferred shareholders
● Market price per share = Current market price of the preferred stock

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If floatation cost is given, then it is deducted from market price and become new market
price.
________________
Impact on Cost of Preferred Stock
Flotation costs increase the effective cost of capital for a company. When calculating
the cost of preferred stock, it's essential to adjust for these costs.
Adjusted Cost of Preferred Stock
The adjusted cost of preferred stock (Rp) can be calculated using the following formula:
Rp = (Dividend per share / Net proceeds per share)

Where:
● Net proceeds per share = Market price per share - Flotation cost per share
Example
Assuming a preferred stock with a par value of $100, a dividend rate of 8%, a market
price of $95, and a flotation cost of $5 per share:
● Dividend per share = $100 * 8% = $8
● Net proceeds per share = $95 - $5 = $90
● Cost of preferred stock (Rp) = $8 / $90 = 0.0889 or 8.89%

Cost of common stock

The cost of common stock, also known as the required return on common stock (rs),
represents the expected rate of return an investor can expect to earn on holding a
particular common stock.
Here's an overview of the two main methods for calculating the cost of common stock:
1. Dividend Discount Model (DDM):
The DDM is a valuation model that uses the expected future dividends of a company to
estimate its intrinsic value. It involves the following formula:
rs = (D1/P0) + g

where:
● rs = Cost of common stock
● D1 = Expected next dividend per share
● P0 = Current market price of the share
● g = Growth rate of future dividends (assumed to be constant)

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By calculating the present value of all future dividends using this formula, investors can
estimate the intrinsic value of the stock and determine if it's trading at a fair price.
2. Capital Asset Pricing Model (CAPM):
The CAPM is a widely used model that estimates the expected return on an asset based
on the risk of the asset and the risk-free rate. It involves the following formula:
rs= RF + βj X (rm - RF)

where:
● rs = Cost of common stock
● r_f = Risk-free rate
● beta = Beta of the asset (measures the asset's sensitivity to market risk)
● rm = Market risk premium (excess return on the market over the risk-free rate)
By comparing the expected return of a stock to the CAPM's expected return, investors
can assess whether the stock is undervalued or overvalued based on its level of risk.
Cost of retained earnings.
Rr=rs and no floatation cost
__________________

Cost of new issues of common stock

The cost of new issues of common stock, also known as the flotation cost,
represents the expenses incurred by a company when issuing new shares to raise
capital. These costs include underwriting fees, legal fees, and registration fees.
Impact on Cost of Capital
Flotation costs increase the overall cost of equity for a company. When calculating the
cost of equity using models like the Dividend Growth Model or the Capital Asset Pricing
Model (CAPM), the flotation cost should be adjusted for to accurately reflect the true
cost.
Adjusting the Cost of Equity for Flotation Costs
The formula to calculate the adjusted cost of equity is:
Cost of Equity = (Dividend per share / Net proceeds per share) + Growth rate
Where: Net proceeds per share = Issue price per share - Flotation cost per share
Example
If a company issues new common stock at a price of $20 per share, with a flotation cost
of $2 per share, a dividend of $1.50, and an expected dividend growth rate of 5%, the
adjusted cost of equity would be:
● Net proceeds per share = $20 - $2 = $18
● Cost of equity = ($1.50 / $18) + 0.05 = 0.1333 or 13.33%

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Calculating the Weighted Average Cost of Capital (WACC)

After Tax WACC

After Tax WACC= rd(1-T)*Wd+re*We

Important Points:

• The weights must be nonnegative and sum to 1.0

• The weights are based on the market value of each capital source as a
percentage of the market value of the firm’s total capital
• We multiply the firm’s common stock equity weight, ws, by either the required
return on the firm’s stock, rs, or the cost of new common stock, rn
• We multiply the firm’s cost of debt by (1 − T) to capture the tax deduction tied to
interest payments
• In weightage average of book value, we consider retain earning also.
Other Key Points:

● Project-Specific Cost of Capital: For projects with different risk profiles than the
company's average, a project-specific cost of capital should be used.
● Value Additivity Principle: The value of a firm is the sum of the values of its individual
projects.
● Discount Rate for Projects: Each project should be discounted at its own opportunity
cost of capital, reflecting its specific risk.
● Risk and Return: Projects with higher risk require higher expected returns.

Chapter 16 Does Debt Policy Matter

Modigliani and Miller Proposition I: Irrelevance of Capital Structure
MM Proposition I is a foundational theory in corporate finance that states under certain
assumptions, a company's capital structure (the mix of debt and equity financing) does not
affect its overall value.

Key Assumptions:

1. Perfect Capital Markets: There are no transaction costs, taxes, or bankruptcy costs.
2. Investors Have Homogeneous Expectations: All investors have the same information
and expectations about future cash flows.
3. No Agency Costs: There are no conflicts of interest between managers and
shareholders.
Implications:

● Value Independence: The value of a company is solely determined by its real assets and
operations, not by how it is financed.
● Arbitrage Opportunities: In a perfect market, investors can create their desired leverage
by borrowing or lending personally. This eliminates any advantage or disadvantage

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associated with a company's capital structure.

● Cost of Capital: The overall cost of capital (WACC) remains constant regardless of the
debt-equity ratio.
Example:

Imagine two identical firms, Firm A and Firm B. Firm A is financed entirely with equity, while Firm
B has a mix of debt and equity. According to MM Proposition I, if all the assumptions hold true,
the total value of Firm A will be equal to the total value of Firm B.

In conclusion, while MM Proposition I provides a theoretical foundation, it's important to

consider real-world factors when making capital structure decisions. Factors like taxes,
bankruptcy costs, and agency problems can significantly affect a company's value and the
optimal capital structure.

Modigliani and Miller Proposition II: The Impact of Taxes

MM Proposition II extends the analysis of capital structure by introducing corporate taxes. It
states that in a world with corporate taxes, a company's value increases with the use of debt
financing.

Key Points:

• Tax Shield: Interest payments on debt are tax-deductible, reducing the company's tax
liability. This creates a tax shield benefit. (Interest * Tax)
• Increased Value: The present value of the tax shield increases the overall value of the
firm.
• Optimal Capital Structure: Companies should aim to use debt to maximize the tax
shield benefits while considering the trade-offs of increased financial risk.
Formula:

• Value of the firm with debt (VL) = Value of the firm without debt (VU) + Present Value of Tax
Shield
Example: The present value of the tax shield for Firm B would be calculated based on the
interest payments and the tax rate.

Here's how MM Proposition II can be used to calculate the expected rate of return on
equity:

1. Calculate the overall cost of capital (ra): This can be done using the Weighted Average
Cost of Capital (WACC) formula, which considers the cost of both debt and equity.
2. Determine the cost of debt (rd): This can be estimated using various methods, such as
the yield to maturity on the company's existing debt.
3. Calculate the debt-to-equity ratio (D/E): This is the ratio of the market value of debt to
the market value of equity.

Use the MM Proposition II formula:

𝐷
𝑅𝑒 = 𝑅𝑎 + (𝑅𝑎 − 𝑅𝑑 ) × 𝐸
○ Where:
o re = expected return on equity
o ra = overall cost of capital
o rd = cost of debt
o D/E = debt-to-equity ratio

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Chapter-13 Leverage and Capital Structure

Leverage refers to the use of borrowed funds to increase the potential return on an investment,
but it comes with increased risk. It can be classified into two main types: operating leverage and
financial leverage.

Operating Leverage
Operating leverage measures the sensitivity of a company's operating income to changes in
sales volume. It is determined by the ratio of fixed costs to variable costs. A high degree of
operating leverage means that a small change in sales volume can lead to a large change in
operating income.

Formula for Operating Leverage (DOL):

% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝐷𝑂𝐿 = or
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠 𝐸𝐵𝐼𝑇

• Contribution= Sales - Variable Cost

• EBIT= Contribution- Fixed Cost

Another Formula:
𝑄 × (𝑃 − 𝑉𝐶)
DOL at base sales level 𝑄 =
𝑄 × (𝑃 − 𝑉𝐶) − 𝐹𝐶

Financial Leverage
Financial leverage measures the sensitivity of a company's earnings per share (EPS) to changes
in operating income. It is determined by the ratio of debt to equity. A high degree of financial
leverage means that a small change in operating income can lead to a large change in EPS.

Formula for Financial Leverage (DFL):

% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆 𝐸𝐵𝐼𝑇
𝐷𝐹𝐿 = % 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇 or 𝐸𝐵𝑇

• EBT= EBIT-Interest
• EPS= PAT (Net Income) / No of common shares

Another formula:
EBIT
DFL at base Level EBIT = (13.7)
1
EBIT − 𝐼 − (𝑃𝐷 × 1 − 𝑇 )

Where PD is the preferred stock dividend.

Combined Leverage
Combined leverage is the combined effect of operating and financial leverage. It measures the
overall sensitivity of a company's EPS to changes in sales volume.

Formula for Combined Leverage (DCL):

DCL = DOL * DFL

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% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛

𝐷𝐶𝐿 = % 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠 or 𝐸𝐵𝑇

Break-even Analysis
Break-even analysis is a financial tool used to determine the point at which a company's total
revenue equals its total costs. This point is where the company neither makes a profit nor a loss.

Setting EBIT equal to $0 and solving for Q yields:

𝐹𝐶
𝑄=
𝑃 − 𝑉𝐶
Value of Firm
• Without Tax
Value of equity= PAT/Re

• With Tax

Optimal Capital Structure

EBIT × (1 − 𝑇) NOPAT
𝑉= = (13.11)
𝑟wacc 𝑟𝑤𝑎𝑐𝑐
where:

EBIT = Earnings before interest and taxes

T = tax rate
NOPAT = Net operating profits after taxes, which are the after-tax operating earnings available to
the debt and equity holders, EBIT * (1−T)
rwacc = Weighted average cost of capital

Estimating Value

• The value of the firm’s stock associated with alternative capital structures can be estimated
using one of the standard valuation models

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• If, for simplicity, we assume that all earnings are paid out as dividends, we can use a
standard zero growth valuation model such as that developed in Chapter 7

• By substituting the expected level of EPS and the associated required return, rs, we can
estimate the per-share value of the firm, P0
EPS
𝑃0 = (13.12)
𝑟𝑠

Additional Cash Flow = (Value of Firm with Debt - Value of Firm without Debt) + (Debt * Cost of
Debt * (1 - Tax Rate))

Interest Expense on Debt:

The firm is converting ₹4 million of equity into debt at a cost of 10%. The annual interest
expense will be:

Interest Expense = Debt * Interest Rate

• Interest Expense = ₹4,000,000 * 10% = ₹400,000

Tax Shield on Interest Expense:

• The tax shield is the amount of tax saved due to the interest expense being tax-deductible.
• Tax Shield = Interest Expense * Tax Rate
• Tax Shield = ₹400,000 * 34% = ₹136,000

Levered Net Income:

The levered net income is the EBIT minus interest expense, and then we apply the tax rate.

• Levered Net Income = (EBIT - Interest Expense) * (1 - Tax Rate)

• Levered Net Income = (₹2,000,000 - ₹400,000) * (1 - 34%)
• Levered Net Income = ₹1,600,000 * 66% = ₹1,056,000

Total Cash Flow to Peter when Firm is Levered:

• Peter holds all the debt, so he receives both the net income and the interest payments.
• Total Cash Flow to Peter (Levered) = Levered Net Income + Interest Expense
• Total Cash Flow to Peter (Levered) = ₹1,056,000 + ₹400,000 = ₹1,456,000

Total Cash Flow to Peter when Firm was Unlevered:

• When the firm was unlevered, Peter would receive the net income after taxes.
• Total Cash Flow to Peter (Unlevered) = EBIT * (1 - Tax Rate)
• Total Cash Flow to Peter (Unlevered) = ₹2,000,000 * (1 - 34%) = ₹2,000,000 * 66% =
₹1,320,000

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Difference in Cash Flow:

• The difference in cash flow is the cash flow when levered minus the cash flow when
unlevered.
• Difference = Total Cash Flow to Peter (Levered) - Total Cash Flow to Peter (Unlevered)
• Difference = ₹1,456,000 - ₹1,320,000 = ₹136,000

Unlevered Levered
EBIT 20,00,000 20,00,000
Int 0 4,00,000
EBT 20,00,000 1,60,00,000
Tax 6,80,000 5,44,000
PAT 13,20,000 10,56,000
Total Cash Flow 13,20,000 14,56,000

Chapter-14 Dividend Policy

Firms pay Dividend by

• Cash dividend - commonest method. Firm pays out part of cash earned to stockholders,
called dividend. Two types - regular and special.
• Stock Dividend - firm gives additional shares.

Mechanics of a dividend, which is a distribution of a company's profits to its shareholders.

Here's a breakdown of the key dates involved:

1. Declaration Date:

This is the date when the company's board of directors officially announces their
●
intention to pay a dividend.
● They specify the amount of the dividend, the record date, and the payment date.
2. Cum-Dividend Date:

● This is the last date on which a buyer of the stock will receive the upcoming dividend.
● If you buy the stock before this date, you will be entitled to the dividend.
3. Ex-Dividend Date:

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● This is the date after which a buyer of the stock will not receive the upcoming dividend.
● The seller retains the dividend.
● The stock price typically drops by the amount of the dividend on the ex-dividend date.
4. Record Date:

● This is the date on which the company determines who is entitled to receive the dividend.
● Shareholders who own the stock on this date will receive the dividend.
5. Payment Date:

● This is the date when the dividend is actually paid to the shareholders.

How should stock prices behave?

Stock Buybacks
• Definition: A stock buyback, also known as a share repurchase, is when a company
buys back its own shares from the marketplace.
• Popularity: This method has gained popularity globally as a way for companies to return
value to shareholders.
• Mechanism: Companies typically offer to buy back shares at a premium over the
current market price, making it attractive for shareholders to sell.
• Impact:

o Reduced Shares Outstanding: The total number of shares in circulation

decreases, which can increase the value of remaining shares.

o Capital Gains: Shareholders who sell their shares back to the company may
incur capital gains, which are subject to capital gains tax.

Benefits of Stock Buybacks

• Increased Earnings Per Share (EPS): With fewer shares outstanding, the
company’s earnings are spread over fewer shares, potentially increasing the EPS.
• Flexibility: Unlike dividends, which create an expectation of regular payments,
buybacks can be more flexible and opportunistic.

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• Signal of Confidence: Buybacks can signal to the market that the company believes
its shares are undervalued.

Considerations

• Tax Implications: As you mentioned, investors may face capital gains tax on the
profits from selling their shares.
• Market Perception: While buybacks can be seen as a positive signal, they can also
be viewed as a lack of better investment opportunities within the company.

Dividend vs Buybacks

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Schools of Thought on Dividends

1. Dividends are Valuable: Some investors prefer regular dividends.

2. Buybacks are Valuable: Other investors prefer stock buybacks.

3. Indifferent: Some investors are indifferent between dividends and buybacks.

Modigliani and Miller (1961)

• Irrelevance Theory: Dividend policy is irrelevant to a firm’s value if investment policies

are fixed and there are no taxes.

• Key Argument: Investors can create their own cash flows by selling shares if needed, so
they won’t pay more for firms with higher dividends.

Tax Implications

• Dividends vs. Capital Gains: Dividends are generally taxed higher than capital gains.
The ex-dividend date can provide insights into investor preferences.

Reasons for Paying Dividends

• Bad Reasons:

o Bird in the Hand Fallacy: Preferring dividends because they are immediate and
certain.

o Excess Cash Argument: Paying dividends just because there is excess cash.

• Good Reasons:

o Clientele Effect: Catering to investors who prefer dividends, such as retirees.

o Signaling: Dividends can signal financial health to the market.

o Wealth Transfer: Transferring wealth from bondholders to stockholders.

Share Buybacks in India

• Methods: Open offer, tender offer, targeted buyback, and book building option.

Stock Dividends and Splits

• Stock Dividends: Additional shares given to shareholders, increasing the number of shares
outstanding.
• Stock Splits: Shares are split into a higher number of shares, reducing the price per share.

Evaluating Dividend Policy

• Cash Flow Focus: Dividends are paid from cash, not net income.
• Investment Opportunities: Consider if the firm has positive NPV projects.
• Management Track Record: Assess how management has handled excess cash in the
past.

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Dividend Policy and Clientele

• Scenario: If a firm historically pays large dividends but plans to invest in new markets, it
must decide whether to cut dividends, defer investments, or issue new stock.

Value Creation

• Investing Decision: Invest where benefits exceed costs.

• Financing Decision: Optimize the mix of debt and equity.
• Payout Decision: Reinvest if there are value-enhancing opportunities; otherwise,
pay out based on investor preferences.

Ankit Pantula FM-II Notes