BUSINESS FINANCE – FINS1613SUMMARY

1.1 Finance: A Quick Look

The four main areas of finance are: Corporate Finance – Business Finance

o Making corporate decisions. Raising capital Investment decisions from manager’s point of view Maximizing firm value Distributing earnings to shareholders

o Financial firms are referred to as the sell side of the marketo Investment banks

Investmentso Deals with financial assets, such as equity(shares) and debt

Pricing of risk and determination of returnso Financial firms involved are referred to as the buy side of the market.o Superannuation funds, hedge funds, investment management and brokerage firms

Financial Institutionso Businesses that deal in financial matters.o Commercial side: Originations and extensions of loans to businesseso Consumer side: Originations and extensions of mortgage loans or other personal loans.o Determine whether an extension to a loan is warranted based on financial position and

performance.o Insurers determine risks and the insurance premiums for that risk.

International Financeo International aspects of corporate finance, investments and financial institutions.o Political risk, exchange rate risk, commodities and international market risk, international

business and market conditions.o Multinational corporations and financial institutions with overseas operations.

1.2 Business Finance and The Financial Manager

When starting a business you have several financial decisions to make, the most important ones include: Investment – amount and type of investments to make determine size, profits, risk, liquidity Financing – how the firm will raise money affect financing costs and financial risk (Capital

Budgeting) How everyday finance matters are going to be addressed, i.e. collecting money from debtors, etc…

(Capital Structure) Dividend – how much of profits are given out as dividends vs retained (Working Capital Management)

The role of financial managers are to answer these questions: The top financial manager within a firm is usually the chief financial officer (CFO) Business Finance deals with the decisions made by corporate treasury and capital expenditures.

1

Capital budgeting: The process of planning and managing a firm’s long term investment decisions. Management aims to identify whether long term investments are profitable or not Determine the size of cash flow, the timing of cash flows and the risk of future cash flows.

Capital structure: The mixture of debt and equity maintained by a firm. How the firm obtains the financing it needs to support its long term investments. How much should the firm raise, what are the least expensive sources of funds for the firm.

Working Capital: A firm’s short term assets and liabilities Managing the firm’s working capital is a day-to –day activity that ensures the firm has sufficient

resources to continue its operations and avoid costly interruptions.o How much cash, inventoryo Sell on cash or credit to customerso Source of short term financing (Where and How)

1.3 Forms of Business Organisation

Types of companies: Sole proprietorships:

o A business owned by a single individualo Simple to establish, few regulations, owners keeps all profits., avoid corporate income taxo Difficult to raise large capital, unlimited liability, only lasts as long as owner, transfer of

ownership is difficult Partnerships:

o Owned and run by two or more people informal or legally bindingo Cheap and easy to establisho General partners have unlimited liability, limited partners have limited liability

A limited partner do not have much say in how the business is runo Difficult to raise capital, only lasts as long as owner, difficult to transfer ownership

Corporations:o A business created as a distinct legal entity owned by one or more individuals or entities.

Has the same rights as a ‘person’ – can borrow money, own property, sue/d, enter partnerships, etc…

o Unlimited life, easily transfer ownership, limited liability, easy to raise capitalo Liable for corporate tax, and then dividends are taxed when paid to shareholders, difficult to

setup as legal formalities are lengthy and costly Charter includes: name, purpose, share amounts, directors, whether shares are issued to

new investors or existing owners. o Owners are separate to management.

2

1.4 The Goal of Financial Management

Profit Maximisation: Profit maximisation is a very airy-fairy term and is not specific.

o What profits? End of year? Before tax? After tax? Will it be achieved through cost-cutting which may have negative long-term impacts?  Does it refer to earnings per share or accounting net income?

The Goal of Financial Management in a Corporation: Maximise the current value of the existing shares

o Assuming shareholders purchase shares to make a capital gain and financial managers make decisions for shareholders

Maximise the market value of the existing shareholder’s equity. o If the corporation is not listed on an exchange and has no shares.

Social and ethical responsibilitieso safety and welfare of employees, customers, environmento Not conducting illegal operations to maximize firm value

ASX introduced a Corporate Governance Council to recommend guidelines on best practice.

1.5 The Agency Problem and Control of the Corporation

Agency Relationships: The relationship between shareholders and management is called an agency relationship. Whenever one group (principles) hire another (the agent) to perform a service, there is a potential

conflict of interest, such a conflict is called an agency problem.

Management Goals: Managers are different to shareholders, they may not have the same objectives. A corporation is considering a new investment, which is relatively risky, but will increase share price.

Management does not go ahead with the investment, in the fear that it might fail and they may lose jobs. o Shareholders lose out on a possible increase in share price. o This is known as an agency cost, when managers fail to take advantage of a valuable opportunity

for the firm. 

Do Managers Act in The Shareholders’ Interest? Whether managers act in the best interest of shareholders, depends on two issues:

o How closely aligned are the management goals with shareholder growtho The job security of management – can they be replaced in shareholder interest are not pursued.

Managerial Compensation is dependent on firm productivity and firm profitability. Further, managers are given stock in a company and thus reducing the agency problem (they will act in the best interest of the shareholders — because they are shareholders). 

Control of the firm — Control rests with shareholders. Shareholders can engage in a proxy fight to replace existing management. Management can also be replaced by M&A activity (particularly acquisitions), whereby well managed companies acquire poorly managed ones, and former managers are often left jobless. 

Stakeholders: Entities apart from shareholders or creditors that has a claim on the cash flow of the firm. 

3

1.6 Financial Markets and The Corporation

Cash Flows to and from the Firm:1. Firm issues securities to raise cash2. Firm invest in assets3. Firm’s operations generate cash flow4. Cash is paid to government as taxes, other stakeholders may receive cash5. Reinvested cash flows are ploughed back into firm6. Cash is paid out to investors in the form of interest and dividends.

In financial markets it is debt and securities that are bought and sold

Primary versus Secondary Markets: The term primary market refers to the original sale of securities by governments and corporations

o In a primary market transaction, the corporations is the seller and the transaction raises money for the corporation. The two types of transactions are:

A public offering – involves selling securities to the general public (IPOs) A private placement is a negotiated sale involving a specific buyer

o There are a lot of rules and regulations involved with public offerings, and it is expensive and must be registered with Australian Securities and Investment Commission (ASIC)

o Instead corporations often sell securities via private placement to large financial institutions as to avoid legal costs and as it does not have to be registered with ASIC.

The secondary markets are those in which securities are bought and sold after the original sale.o A secondary market transaction involves one owner or creditor selling to another.

The secondary market provides the means for transferring ownership of corporate transactions.

o There are two types of secondary markets: Dealer markets – Over the counter (OTC); Dealers buy and sell for themselves, dealer

makes profit on the difference between the buy and sell price (aim to buy low sell high) Auction market – In the auction market brokers and agents match buyers and sellers and

charges a fee for this service. Auction markets has a physical location. The equity shares of all large firms in Australia and New Zealand trade on organized auction markets

(exchanges)o Shares that trade on an organized exchange are said to be listed on that exchange.

4

4.1 Future Value and Compounding:

Time Value of Money “A dollar today is worth more than a dollar tomorrow”

o You could earn interest on the dollar while you waitedo Inflation, goods will be more expensive tomorrow.

Future Value (FV) Refers to the amount of money an investment will grow to over some period of time at some given

interest rate.o Cash value of an investment at some time in the future.o FV t=Principal×(1+r )t – Principal = Present Value

The process of leaving your money and accumulating interest in an investment is called compounding.o Compounding the interest means earning interest on interest – compound interesto Simple interest is interest earned on the original principal each period.o Compound interest FV ≥ Simple Interest FV

4.2 Present Value and Discounting:

Present Value (PV) Refers to the current value of future cash flows discounted at the appropriate discount rate.

o Reverse of future value. How much the money is worth to you todayo How much you need now, to obtain an amount in the future.

o PV= FV(1+r )n

The process of finding the present value of a sum of money is called discounted cash flow (DCF) valuation

o The discounting rate is the rate used to calculate PV in FV cash flows

5.1 Future and Present Values of Multiple Cash Flows:

For multiple cash flows:

1. Determine the FV/PV of each individual cash flow2. Add the FV/PV of each cash flow to determine the FV/PV of the stream of cash flows.

FV=C1 (1+r )n−1+C2 (1+r )n−2+…+C n

PV=C1

(1+r )+

C2

(1+r )2+

C3

(1+r )3 +…+Cn

(1+r )n

5

5.2 Valuing Level Cash Flows: Annuities and Perpetuities:

Level Cash Flows: Annuity - A series of constant (level) cash flows paid for a finite number of periods

o Ordinary annuity – Payments are made at the end of each periodo Annuities Due – Payments are made at the start of each periodo FV of annuity due > FV of ordinary annuity b/c payments made earlier and therefore earn more

interest Perpetuity – An annuity with infinite number of periods

PV and FV for Ordinary Annuities

PV t :Ordinary Annuity=Cr (1−( 1

1+r )n)

FV t :Ordinary Annuity=Cr

( (1+r )n−1 )

−PV t :GrowthOrdinary Annuity=Cr−g (1−( 1+g

1+r )n)

PV and FV for Annuities Due

PV t : Annuities Due=Cr (1−( 1

1+r )n)(1+r )

FV t : Annuities Due=Cr

( (1+r )n−1 ) (1+r )

PV for Perpetuities

PV perpetuity=Cr

PV growth perpetuity=Cr−g

5.3 Comparing Rates: The Effect of Compounding:

Effective Annual Rate (EAR) The EAR is the actual interest rate you would receive expressed as if it was compounded annually.

o It is the actual rate you receive, not the quoted rate.

Annual Percentage Rate The APR (nominal) is the quoted interest rate per annum with a non-annual compounding.

o Semi-annualo Quarterlyo Monthly

6

EAR=(1+ APRn )

n

−1

Period Rate The rate charged by the lender in each period

o To convert APR into periodic

Periodic Rate= APRn

o To convert EAR into periodic Periodic Rate=(1+EAR )

1n−1

5.4 Loan Types and Loan Amortisation:

Pure Discount Loans The borrower receives funds today and repays as a lump sum with interest at some time in the future.

Interest Only Loans The borrower receives funds today and pays interest only each period and then a lump sum at the end.

Amortised Loans: The borrower receives fund today and pay interest and part of the principal each period.

6.1 Bills of Exchange and Bill Evaluation:

Bill of Exchange A bill is a certain sum of money to be paid to the bearer at a fixed or determinable time in the future. Called a discount security because interest in not explicitly paid.

o You don’t receive the full amount, and then pay back the face value at some time in the futureo The difference between the amount received and face value represents the interest

Face Valueo The principal amount that is repaid at the end of the agreed term. – par valueo The amount stated on the bill

Maturityo Date on which the principal amount is paido Bills are typically issued for a period of days

BillValue= F

1+ r ×t365

6.3 Bonds and Bonds Evaluation:

Bonds A type of interest only loan, where borrower pays interest every period and then principal at the end of

loan. Face Value

o The principal amount of a bond that is repaid at the end of term – par value. Coupon

o Stated interest payment made on a bond – a series of regular interest payments7

Coupon rateo The annual coupon divided by the face value of the bond

Maturityo Date on which the principal amount of a bond is paid

Yield to Maturityo The market required rate of return for the bond.

Bond Pricing: Since a bond consists of coupon payments that are regular interest payments, this equates to an annuity. The principal to be repaid at maturity represent a lump sum payment.

BondValue= Cytm [1−

1(1+ ytm )t ]+ F

(1+ ytm)t

Relationship between Price of Bond and Yield If ytm = coupon rate

o Par value = bond price If ytm > coupon rate

o Par value > bond priceo Discount bond

If ytm < coupon rateo Par value < bond priceo Premium bond

Bond price fluctuates inversely with changes to ytm.

Interest Rate Risk: The risk that arises for bond owners from fluctuating interest rates. Longer maturity bonds have more interest rate risk than shorter bonds

o Effects of discounting are greater on cash flows that are further away in time Lower coupon rate bonds have more interest risk than higher coupon rate bonds

o If coupon rate is lower, the bond’s value has a greater relative weight on the par value, increasing the effects of discounting.

6.4 More on Bond Features:

Bonds are debt investment instruments. A corporation that issues a bond is the borrower/debtor, while the bearer is the lender or creditor

Debt does not represent ownership interest in the firm The interest payment is the cost of using debt as a source of funds.

o Having debts creates risk for financial failure

Bond Characteristics Maturity: short v intermediate v long term Placement: private v public Issuer: corporations v governments Security: secured v unsecured

o In the event that the issuer defaults – the investors have a claim on the issuer’s assets that will enable them to get their money back.

Seniority: senior v junior

8

o Preference in position over other lenders Credit Rating: investment grade v low grade ‘junk’ bonds Issuer exercisable features: callability, covenants

o Ability to repurchase bond before maturity, part of the trust deed limiting certain actions. Exotic Features: convertible, floating, and others

o Bond can be swapped for shares, adjustable coupon payments….

6.8 Inflation and Interest Rates:

Nominal Interest Rates They are the interest rate that are quoted in the market

o They are not adjusted for inflations

Real Interest Rates The real rate of return is the percentage change in how much you can buy with the number of dollars

you haveo The interest rates that have been adjusted for inflations

The Fisher Effect: The relationship between nominal and real interest rates

1+inominal=(1+ireal ) (1+π )

inominal≈ ireal+πWhere π = inflation

6.9 Determinants of Bond Yields:

The Term Structure of Interest Rates Relationship between yield to maturity and time to maturity

o On default free, pure discount securities Normal yield curve – upward sloping structure

o Long term yields are higher than short term yields Inverted yield curve – downward sloping structure

o Short term yields are higher than long term yields

Factors Affecting Required Returns Default risk premium – The portion of a nominal interest rate that represents compensation for the

possibility of default Liquidity premium – The portion of a nominal interest rate that represents compensation for the lack of

liquidity Maturity premium – Longer term bonds will tend to have higher yields.

7.1 Ordinary Share Valuation:

As a shareholder you can receive cash in two wayso Dividends the company payso Selling you shares

9

The value of a share is then the present value of the dividends and the proceeds from selling that share.

P0=D1+P1

1+r

Dividend Discount Model If we continue to just take dividends forever and delay the time at which we sell our share, then the price

of the share is given by:

P0=D1

(1+r)+

D2

(1+r )2 +…+D∞

(1+r )∞=∑

t=1

∞ D t

(1+r )t

Constant Dividends (Zero Growth) Same dividend at regular intervals forever

o Treat it as a perpetuity

P0=Dr

Constant Growth Dividends Dividends is expected to grow at a constant rate every period

D1=D0(1+g)t

The constant growth model has the general equation:

P0=D 0∑t=1

∞ (1+g)t

(1+r )t=D0

(1+g)r−g

=D1

r−g Note:

r=D1

P+g=dividend yield+capital gains yield

o Dividend yield – return from dividendso Capital gains yield – growth rate

Supernormal Dividend Growth Dividend growth in non-constant initially, but it settles down to a constant growth eventually

7.2 Some Features of Ordinary and Preference Shares:

Shares A share is a stake in a company

o An owner who has the right to pick the manages and receive any profits

Ordinary Shares Voting rights:

o Shareholders elect directors

10

o One share one voteo Proxy voting – voting on behalf of other shareholder(s)

The right to share proportionally in dividends paid Rights to remaining assets after liquidation – residual claim

Preference Shares Shares with dividend priority over ordinary shares, normally with a fixed dividend rate, sometimes

without voting rightso Dividends are paid to preference shareholder first, then to ordinary shareholders.

Dividends Common dividends

o Dividends that are declared by the board of directors and paid to ordinary shareholderso There is no liability of the firm until declared

Preference Dividendso Paid to preference shareholders firsto They are not a liability and can be deferred indefinitelyo Dividends tend to be cumulative

10.1 Returns:Financial Market

The financial market is the place where you can raise capitalo It determines the prices of bonds and stocks

Understanding this can help make better decisions pertaining the financial market.o There is a trade-off between risk and returno The higher the risk, the higher the expected return.

Dollar Returns: The return on an investment expressed in dollar terms as:

o Dollar Returns = Dividend Income + Capital Gain/Loss Capital gains is the difference between the price received when sold and price when bought

Percentage Returns Total % Return = Dividend yield + Capital Gain Yield

Total Return=Dt+1+P t+1−P t

Pt

Capital gains yield=Pt+1−PtPt

Dividend Yield=Dt+1

Pt

10.3 Average Returns: The First Lesson:

Historical Average Return: Arithmetic average

11

Historical Average Return=r1+r2+…+rT

T=∑i=1

T

ri

T

Risk-Free Rate Rate of return on a riskless investment Zero risk premium

Risk Premium The excess return on top of risk-free rate ‘Award’ for bearing investment risk

10.4 The Variability of Returns:

Variance (σ 2) The average squared distance between the actual return and the average return

o Variability of returns

VAR (R )=σ2=∑i=1

T

(ri−r)2

T−1

Standard Deviation The positive square root of the variance

o Return volatilityo Often preferred because it is in the same units as average returns

SD (R )=σ=√VAR(R)

Normal Distribution A symmetrical, bell shaped frequency distribution that is completely defined by its average (mean - µ)

and standard deviation (σ). It is useful for describing the probability of ending up in a given range. Returns generally have a normal distribution

10.5 More on Average Returns:

Arithmetic Average Return The return earned in average period over multiple periods

o What was your return in average year Overly optimistic for long horizons

Arithmetic Average=∑i=1

T

ri

TGeometric Average Return

The average compound return earned per year over multiple periodso What was your average compound return per yearo Geometric < Arithmetic

12

Overly pessimistic for short horizons

Geometric Average=[ (1+r1 )× (1+r2 )×…× (1+rT ) ]1T−1¿ [∏i=1

T

(1+r i)]1T−1

Depending on time period: 15 – 20 years: use arithmetic average 20 – 40 years: split the difference between them > 40 years: use geometric average

10.6 Capital Market Efficiency:

Efficient Capital Market Market in which security prices reflect available information

The Efficient Market Hypothesis: Stock prices are in perfect equilibrium Stocks are ‘fairly’ priced Stock markets are information efficient Share prices will always reflect information in the market, hence investors should not expect to earn

positive ‘abnormal’ returns You can still make returns, return is dependent upon the level of risk you are bearing. Poor investment decisions will still lead to poor returns.

Strong Market Efficiency All private and public information is reflected in the prices You cannot make abnormal profits

Semi-Strong Market Efficiency All public information is reflected in the prices You can’t make abnormal profits from public information (fundamental analysis)

Weak Market Efficiency Share prices only reflect historical price and trade information Cannot make abnormal profits based on past price information Technical analysis will not lead to abnormal profits Empirical evidence suggests markets are generally weak.

8.1 Net Present Value

Role of financial manager Capital budgeting

o Choosing what to invest in Capital structure

o Deciding how to finance the investments Working capital management

o Managing every day activities and funds Dividend policy

o How profits will be returned to investors

13

Capital Budgeting Design Criteria Does the decision rule factor in the time value of money Does it factor in risk Does the decision rule tell us if we are creating value for the firm

Independent Projects Projects that have no impact on another project’s cash flows The decision to accept/reject project will have no impact on other projects Firm can accept one or more, or it could reject all

Mutually Exclusive Projects Projects that when you accept, you must decline all other ones

o Could be because of financial constraints or limitation to available assets Projects should be ranked in order to determine which one to take

Net present value (NPV): NPV is the value of an investment taking into account the discounted value of all future cash flows If NPV > 0 then accept as will generate more cash than it costs If NPV = 0 then the project will break even If NPV < 0 then reject If mutually exclusive, choose project with highest NPV

Calculating NPV Estimate future cash flows Estimate required return for the level of risk you are bearing Find PV of cash flows and subtract from initial investment

NPV=∑t=1

n C t

(1+r )t−CF 0

Advantages Meets all decision rule criteria NPV is consistent with firm’s objective of maximizing shareholder’s wealth Preferred method

8.2 The Payback Rule:

Payback period The amount of time it takes for an investment to produce enough cash to cover the initial cost of the

investment

Calculating Payback period Estimate future cash flows Subtract future cash flows from initial cost until initial cost is recovered

Decision Rule Accept project is payback period is less than some predetermined limit

14

Advantages Easy to understand Adjusts for cash flow uncertainty Biased towards liquidity

Disadvantages Ignores time value of money Requires predetermined threshold Ignores cash flow after threshold Biased towards long term projects

8.3 The Average Accounting Return (AAR):

Average accounting return is defined as:

AAR=average net incomeaveragebook value

Average book value depends on how the asset is depreciatedo Take arithmetic mean of first book value and last book value

Decision Rule Accept the project if the AAR is greater than the target rate

Advantages Easy to calculate Required information is readily available

Disadvantages Not a true rate of return Time value of money ignored Uses an arbitrary threshold Based on book values, not market values

8.4 The Internal Rate of Return (IRR):

The IRR is the discount rate that makes the NPV = 0.o Involves trial and error, or excel

Decision Rule Accept the project if IRR is greater than the required return

IRR and NPV IRR and NPV lead to identical decisions iff

o Conventional cash flow – first is negative, rest is positiveo Independent project

If there is a conflict, USE NPV

15

Multiple IRR Non-conventional cash flows lead to multiple IRRs

o Another cash flow begins after the initial outflow IRR is no longer useful in this case

Mutually exclusive projects Using IRRs becomes a problem because the timing and size of cash flow becomes important At some required return the NPVs will crossover and one project will suddenly become more appealing

than the other.

Advantages Easy to understand Knowing a return is intuitively appealing If the IRR is high enough don’t need to calculate required return

Disadvantages Can produce multiple IRRs Cannot rank mutually exclusive projects

Modified IRR Helps control problems of IRR Discount approach

o Discount future outflows to present value and add to initial outflows Reinvestment method

o Compound all cash flows except the first forward to the end Combination method

o Discount outflows to present and compound inflows to the end Discount rates are externally supplied

MIRR v IRR MIRR avoids multiple IRRs Managers prefer rate of return comparisons and MIRR is better for this Different ways to calculate MIRR

o Which one is best? Interpreting MIRR becomes harder

8.5 The Profitability Index:

The profitability index is defined as the present value of future cash flows divided by the initial investment

Measures the value created per dollar invested

Decision Rule Accept project is PI>1.0

Advantages Closely related to NPV Useful when funds are limited

16

Disadvantages The profitability index does not consider the scale of the project, which can lead to incorrect

comparisons of mutually exclusive projects.

9.1 Project Cash Flows:

Relevant Cash Flows A project where the cash flows of the project will increase the firm’s overall cash flows if the project is

taken on

Incremental Cash Flows The difference between a firm’s future cash flows with the project and without the project How much the project will generate for the firm

Standalone Principle The assumption that you can evaluate a project based on its incremental cash flows

9.2 Incremental Cash Flows:

Sunk Costs A cost that has already been incurred and cannot be recovered

o Not a relevant cash flowo Exclude from DCF analysis

E.g. Consulting fees that have already been paid

Opportunity Costs The most valuable alternative that is given up if a particular investment is taken

o Should be considered in DCF analysis E.g. Using a pre-owned building for a project

o Opportunity – we could sell the buildingo Opportunity cost is the amount the building will sell for today

Side Effects The cash flows of a new project that come at the expense of the a firm’s existing project

o Should be considered in DCF analysis E.g. When you launch a new product line, you must consider the loss in sales of other product lines as a

result of this new product

Net Working Capital Changes in the short term that represent the cost of running the day to day business

o Should be included in DCF analysis

Financing Costs We do not include interest paid or any other financing costs, such as dividends or principal repaid on

debt securities Financing effects have already been takin into account by the discount rate.

17

9.3 Pro Forma Financial Statements and Project Cash Flows

Projected Financial Statements Pro forma financial statements are useful for projecting future years’ operations To prepare these statements we require an estimate on

o Unit saleso Selling price per unito The variable cost per unito Total fixed costs

Free Cash Flows Cash flow from assets The incremental effect of a project on a firm’s available cash.

Free cash flow (FCF )=Operating cash flow (OCF )−∆ Net working capital (NWC )−Capital Expenditure (CAPEX )+After tax salvage value

9.4 More on Project Cash Flows

Operating Cash Flows Cash flows generated from a firm’s normal day to day operations Adjust net profit by non-cash items to do not correspond to actual cash flows

o Depreciation

1. OCF=EBIT+Depreciation−Taxes2. OCF=(Sales−Costs )× (1−T )+Depreciation×T

Depreciation Even though depreciation is deducted from net profit, it is not an actual cash outflow

o Thus we add it back to see how much cash has actually been generated The benefit of deducting depreciation is that it reduced the tax paid

o Depreciation tax shield Straight line – write off a fixed amount per year until book value is nil Diminishing value – depreciate a fixed percentage of book value per year

Net Working Capital (NWC) The difference between a firm’s current assets and current liabilities

o Capital available in short term to run business Current accounts such as accounts receivable/payable and inventories

∆ NWC=∆Current assets−∆Current liabilities We must adjust for NWC because:

o We make sales on credit and match it with an appropriate expense, however this is not necessarily when the cash comes in

o There is a timing difference between accounting revenues/expenses and cash inflows/outflows

How to adjust for NWCo Increases in current assets (accounts receivable/inventories) represent cash outflow – deduct

18

o Decreases in current assets represents in cash inflow – addo Increases in current liabilities (accounts payable) represent cash inflows - addo Decrease in current liabilities represent cash outflows - deduct

Capital Expenditure (CAPEX) Payments of cash for long term assets (property, factory, equipment, etc…) Do not immediately appear as expenses, but depreciate slowly Cash flow occurs immediately

o Capital expenditure represents negative cash flow at the start

After Tax Salvage Assets that are no longer need can be sold

o Pay tax on capital gains

Capital gain=Sale price−Book valueBook value=Purchase price−accrued depreciation

After tax cash flow=Sale price−(T ×capital gain )

9.5 Evaluating NPV Estimates:

NPV The NPV’s we calculate are just estimates, there is little certainty in the accuracy of the estimate and

hence we must conduct further analysis. Typically a positive NPV is a good sign that we should take up the project, though we need to further

look at:o Forecasting risk

How sensitive the NPV is change in cash flows The more sensitive the greater the forecasting risk

o Sources of value Why does this project create value

9.6 Scenario and other What-If Analyses:

Scenario Analysis The determination of what happens to NPV estimates when we ask what-if questions. We look at NPV from the best, worst and cases in between Scenario analysis tells us what can possibly happen to our project, but it does not tell us whether we

should take it not,

Sensitivity Analysis Investigation of what happens to NPV when only one variable is changed. The greater the volatility in NPV when that one variable changes the larger the forecasting risk

associated with that variable and the more attention we should give in regars to its estimation.

Problems with Scenario and Sensitivity Analysis Neither can provide a decision rule Ignores diversification

19

o Measures only stand-alone risk If your scenarios end up with mostly positive NPVs you should feel comfortable with taking the project If there is a variable that leads to a negative NPC with only small changes you may want to forego the

project.

9.7 Additional Considerations in Capital Budgeting:

Managerial Options and Capital Budgeting Opportunities that managers can exploit if certain things happen in the future Up until now we have assumed the project is static and that the project’s basic features cannot be

changed, however in reality managers can modify the project as new information becomes available. Ignoring these options in our DCF analysis means that we underestimate our NPV.

Option to Expand If a project has a positive NPV, can we expand the project or repeat it to get a larger NPV

Option to Abandon If we start a project, can we abandon (or scale back) the project if it does not cover its own expenses,

Option to Wait The project can be postponed, to see if conditions improve.

Equivalent Annual Annuity (EAA) The level of annual cash flows that generate the same present value as a project It is used to evaluate alternative projects with different lives.

EAA= PV1r(1− 1

(1+r )n)

When making a decision we must factor:o The required life of the projecto The replacement costs

11.1 Expected Returns and Variances:

Expected Return The expected return on an asset is given by:

E (R )=∑i=1

n

p iRi

Where: o pi is the probability that state ‘i’ can occuro Ri is the expected future return of the asset if state ‘i’ occurso N = total number of possible states

Expected return is the return you would expect to get if you repeat s process many timesExpected Return Risk

20

E (σ )=√∑i=1

n

p i[R i−E(R)]2

11.2 Portfolios

Portfolio Group of assets such as shares and bonds held by an investor

o Portfolio weight – percentage of the total value of portfolio in a particular asset. The risk and return of a portfolio are entirely determined by the risk and return of the individual assets

that make up the portfolio.

Portfolio Expected Returns The portfolio expected return is weighted average of the expected return of each asset in the portfolio

E(R¿¿ p)=∑j=1

m

w jE (R j )¿

Where:o Wj is the portfolio weight of asset ‘j’ o Rj is the return of asset ‘j’o M = total number of assets

The expected return on a portfolio can also be calculated by determining the portfolio return in each of the future states and then computing the expected value as we did for individual securities.

E(R ¿¿ p)=∑i=1

n

p iRP,i ¿

Where:o i= particular state out of the possible n stateso pi is the probability that state ‘i’ can occuro RP,i is the expected future return of the asset if state ‘i’ occurso n = total number of possible states

Portfolio Risk We first find the expected portfolio return, then compute the portfolio return standard deviation using

the same formula as individual assets:

E(R¿¿ p)=∑j=1

m

w jE (R j )¿

E (σ p )=√∑i=1

n

pi[RP ,i−E (RP)]2

21

11.3 Announcements, Surprises and Expected Returns:

Expected and Unexpected Returns: The expected return and the realized future return are usually not equal. There is an unexpected component that is not anticipated at time ‘t’ that occurs at time ‘t+1’

o Denoted by U=ϵ t+1

Total Return=Expected return+UnexpectedreturnRt+1=E (R t+1 )+ϵ t+ 1

In efficient markets abnormal profits have zero expected value, hence:o E [ϵ t+1 ]=0o This suggests current market expectations are not biased

11.4 Risk: Systematic and Unsystematic:

Total Risk Total risk = asset’s market risk + asset’s specific risk

Market Risk A risk that influences a large number of assets. Also called systematic risk E.g. GDP, unemployment, interest rates, exchange rates, etc…

Asset Specific Risk A risk that affects at most a small number of assets. Also called unsystematic/diversifiable risk. E.g. Employment Strike within company

11.5 Diversification and Portfolio Risk

Diversification Spreading an investment across a number of assets will eliminate some but not all, of the risk. With many assets in a portfolio positive/negative shocks specific to each asset will cancel each other

out, reducing overall risko More assets, less unsystematic risk

Market risk affects all securities, thus no matter how many assets in a portfolio, market risk cannot be eliminated.

11.6 Systematic Risk and Beta

Systematic risk principle The expected return on a risky asset depends only on the asset’s systematic risk.

Measuring Systematic Risk The beta coefficient is the amount of systematic risk present in a particular risky asset relative to that in

an average risky asseto In other words it is a measure of a stock’s risk relative to the market portfolio.

We define the market portfolio to have a β=1 Thus stocks with β>1 are particularly sensitive to market fluctuations and a stock with β<1 are less

sensitive.

The risk premium of an asset is tied to the market risk premium:22

Market risk premium = rM−r f Risk premium on asset A = r A−r f

E [r A−rf ]=β A×E [rM−r f ]

What is the relationship between beta and risk? Beta only measures the risk of a stock relative to market fluctuations. However, a stock with a low beta may still be risk overall and a stock with a high beta might have lower

overall risk. You tend to find high beta stocks in companies that are in high procyclical industries

Portfolio Beta The weighted average of the betas of the securities in the portfolio.

βP=∑i=1

n

w i β i

11.7 The Security Market Line

Capital Asset Pricing Model (CAPM) It is the relationship between an asset’s risk premium and the market risk premium

E [r A−rf ]=β A×E [rM−r f ]

The CAPM defines the relationship between risk and return for any asset.

E [r A ]=r f +β A× E [rM−rf ] This means that returns come from either:

o Compensation on time value of money, R fo Asset’s risk premium, β A×E [rM−r f ]

Security Market Line The relationship between expected returns and betas can be graphically represented by a straight line.

o This representation is called the Security Market Line(SML) The reward to risk ratios must be the same across all assets since they are all on the same SML

o This is just the gradient of the SML

SMLSlope=E [Ri ]−R f

βi If the portfolio is the market portfolio then the SML slope changes to: SMLSlope=E [Rm ]−Rf

o Since β=1

SML Graph

23

R (%)[Required return]

Undervalued

Rm Overvalued

R f

Risk (ß) ß = 1

Key Terminology Expected return – return market expects from the asset in the future calculated from price and

expected cash flows – IRR Realized return – past return received by investors in the asset mean of actual previous returns Required return – return calculated from theory based on asset’s market risk

Motivations for estimating cost of capital:o To provide required rate of return (hurdle rate) to use in DCF evaluationo To provide cost of capital for accounting calculations of Economic Value Added (EVA)o Regulators setting prices for monopoly --> aim for zero EVA

Components of capital:o Debt:

Money raised from investors in return for contractual payments Long term (bonds or debentures), Short term (bank bills, overdraft) Debt may be secured --> ↓ default therefore ↓ cost of secured debt --> hence ↑ risk and cost

of other unsecured debt Cost of debt = kd

o Preferred shares: Receive fixed dividends Preferred because no dividend can be paid on ordinary shares until preferred shareholders

have been fully paid Equity because no legal right to dividend, can only be paid from profit Companies will pay preferred dividends of they can Cost of preferred stock = kp

o Ordinary equity: Owners of company

24

Entitled to all remaining funds after other have all been paid Vote at general meetings, appoint/remove directors All limited companies must have shareholders Cost of ordinary equity = ks

o Watchpoints: Balance sheets prepared using accrual accounting --> finance techniques such as DFC uses

cash accounting – therefore components of capital ≠ balance sheet headings Equity shares, retained profits, reserves only distinguished for tax purposes --> in finance all

are ordinary equity Trade creditors, accruals are all cash flow timing issues --> in finance, cash flow is explicit –

only interested in point where it becomes cash flows and hence not part of cost of capital Tax considerations rationale:

o Usually calculate costs of capital after allowing for company tax because: Maximizing shareholder value is maximizing after tax value To capture investment decisions on tax related cash flows

o Tax allowable debt: Market return is after tax cost of capital for equity Interest is tax deductible for the company If company is paying tax, after tax cost of debt =

(1-t) x (Market cost of debt) Historic vs current market costs:

o Should we use market cost of capital, or cost of the capital to us eg) from retained profits?o Opportunity costs issue --> must use current market costso Rationale – could also use this money to repurchase securities --> this would save the company the

market cost of capital = opportunity cost. Alternatively, the investors could reinvest their capital at market rate – must use as hurdle

Estimating component costs of capital:o Debt:

Pretax cost of debt = market yield to maturity of issued debt After tax cost of debt = pretax cost of debt x (1-t) ie. kdAT = kdBT(1-t) To calculate yield when not given:

Set up in bond (or other) calculation formula If x% coupon and x% market rate – will trade at FV…so if P > FV, yield < x% Estimate yield…if value > P, yield must be ↓ etc

o Preferred shares: Assume companies will always pay preferred dividend when calculating cost of capital --> as

failure to pay often results in vote entitlement which dilutes ordinary shareholder control Perpetual preferred shares are a perpetuity Cost = dividend / price Pp = Dp / kp --> kp = Dp / Pp Dividends of preferred stock not tax deductible Do not adjust for tax or floatation cost

o Equity: CAPM:

Uses SML relationship ks = krf + ßs(km – krf) For:

o Backed by theoryo Consistent – uses market data to estimate market cost of equity

25

Against:o Only useful for listed companieso Estimation problems for ßo Assumes shareholder diversified

Discounted cash flow from dividend growth model: Current price = discounted PV of future dividend cash flows ks = k(^)s = (D1 / Po) + g(^) Estimating growth rate:

o From analysts’ estimateso Expected growth = retention rate x ROE, where:

ROE is the expected future return on equity Retention rate is the % of equity earning retained ie. (1 – payout ratio)

For:o Only requires single current share price and dividendo May be used for unlisted company (price derived from private transactions)o No assumption that shareholders are diversified

Against:o Very hard to estimate growth rateo Using retention ratio x ROE is using accounting data to estimate market cost

of equity Own bond yield plus risk premium:

Assumes relative bond yields reflect relative equity risk ks = bond yield + risk premium Risk premium – judgement --> 3-5% For:

o Simple to implement --> used by those who don’t understand other methods Against:

o No theoretical basiso Bond yields are assumed to reflect difference in equity risk between

companies: Bond determinants – maturity, coupon, r, default risk Equity risk determinants – earning variability, market correlation,

leverage Only leverage and default risk are somewhat related

Should you average? – averaging does not imply better answer --> judgement call Floatation costs (of equity):

o Cost of raising new capital eg) brokers, underwriterso Negative signal that raising new equity may sendo Approaches:

Add to initial investment cost Allow for in calculation via DCF model:

ks = D1 / Po(1-F) + g(^)o Depends on type of capital and markets perception (re company riskiness and

negative signal)o Mainly issue with equity, but equity raising infrequent --> cost per project

smallo Often ignored or treated outside the evaluation of other decisions

Notes: Can use any one of above, or combination --> judgement needed

26

No correct answer --> estimates are imprecise WACC (Weighted average cost of capital):

o Cost to company of securities sold to raise funds = return to investor of holder that portfolioo WACC = k = wdkd(1-t) + wpkp + wsks

o Factors influencing WACC: Investment policy of firm --> riskiness of its assets - ↑ risk = ↑ WACC Market conditions eg) r, average risk premium Firm’s capital structure and dividend policy

o Tax imputation and WACC: Effective company tax rate and tax subsidy for debt will be ↓ depending on amount of

company tax which is claimed as personal tax Dividends must be grossed up by the attached franking credits eg) for cost of equity with

DFC, market/company return for CAPM regressiono WACC as hurdle rate:

Projects should be evaluated with cost of capital appropriate to the risk WACC is average cost for all companies activities --> need some adjustment for individual

projects Results of not adjusting for risk: (graph)

↓ risk but positive NPV projects will be rejected ↑ risk but negative NPV project will be accepted average company risk will ↑ returns to shareholder will be ↓ than they should be

o Types of project risk: Standalone risk – cash flow variability Corporate risk – effect of project on total firm cash flow Market risk – effect on firms market / beta risk

Market risk is theoretically correct for maximizing wealth of diversified shareholder Corporate risk relevant to undiversified shareholder, creditors and employees Balance these considerations using judgements

o Project risk adjustment procedures: Subjective adjustment of WACC for projects of different risk Evaluate project as if standalone company and estimate ß for market risk adjustment Use one of above to establish cost of capital for each division and use that for the division’s

projects: Pure play – find companies that operate only in the same areas as the division,

estimate and average ßs --> difficult Accounting beta – regress divisions ROA against ROA of companies in similar

markets --> these ßs are somewhat correlates, but difficult to get ROAs for projects that don’t exist

Week 11 onwards… Capital Structure:

o Financial leverage – use of debt and preferred stocko Financial risk – additional risk resulting from financial leverageo Example re financial leverage…

Ratios: BEP – Basic Earning Power = EBIT / assets ROE – Return on Equity = NI after tax / OE TIE – times Interest Earned = EBIT / interest

Conclusions:

27

To ↑ expected ROE, must have BEP > kd because if not, then interest expense > operating income produced by debt-financed assets; therefore leverage ↓ income

As debt ↑, TIE ↓ because EBIT is unaffected by debt and interest expense ↑ (Int Exp = kdD)

BEP is unaffected by financial leverage The effects of taxes on capital structure:

o Classical tax system: Company income is taxed, then shareholders pay tax on dividends

o Imputation taxation systems: Company tax is paid, shareholders get a franking credit on dividends Capital gains tax – tax paid on real capital profits (1/2 personal rate)

o Effect on value of the firm: VL = VU + [ tcI / kd ] VL = VU + PV of annual tax savings Effectively get govt paying some of your interest repayment as it is tax deductible why

not borrow everything Costs of financial distress:

↑ firm borrows, ↑ probability it will default Direct costs – liquidation costs (legal, accounting fees) Indirect costs – lost sales, ↓ value for assets in illiquid markets, managerial time, firm

specific human capital etc Thus, Value = Value if all equity financed + PV of tax savings – PV of expected

bankruptcy costs Company taxes and personal taxes:

o VL = VU + [ 1 – (1 – t c )(1 – t s ) ] D (1 – td)

where tc – corporate tax rate , ts – shareholder tax rate (average div + cap gains rates), td – debt tax rate

o Provide [ ] > 0, VL > VU

o But with imputation, no advantage for un/levered firmo Imputation removes any tax advantage for debt, other reasons for debt – if

return > cost Business risk:

o Uncertainty about future operating income (EBIT) how well can we predict operating income?o Business risk does not include financing effectso Determinants of business risk:

Uncertainty about demand (sales) ↑ variability, ↑ risk Uncertainty about output prices Uncertainty about costs Product, other types of liability Operating leverage:

Use of fixed costs rather than variable costs If more costs are fixed (ie. do not ↓ when demand falls) ↑ operating leverage Effect of operating leverage:

o ↑ operating leverage ↑ business risk (because small sales ↓ causes big profit ↓ ↑ break even point ↑ area to make a loss, but past break even point ↑ profit region ie. ↑

region of profit and losses Profits can by ↑ by ↑ FC mechanise production process

28

↑ variable costs may work, may not Operating leverage can ↑ E(EBIT), but also ↑ risk ↑ in mean but at

cost of dispersion ie risk Business risk vs financial risk:

o Business risk depends on business factors – competition, product liability, operating leverage shared between shareholders and debt holders

o Financial risk depends only on the types of securities issued ↑ debt = ↑ financial risk shareholders only

Operating leverage and financial leverage combined:o Degree of operating leverage: DOL = 1 + (FC / NI)o Degree of financial leverage: DFL = 1 + [ I / (FC + NI) ]o Degree of total leverage: DTL = DOL x DFLo Questions…

Optimal capital structure:o Capital structure (mix of debt, preferred and common equity) at which P0 is maximisedo Trades off ↑ E(ROE) and EPS against ↑ risk the tax benefits of leverage are exactly offset by the

debt’s risk costso Target capital structure is mix with which firm intends to raise capitalo If debt levels ↑, riskiness of firm ↑o This ↑ riskiness = ↑ cost of debt, but also equity (ks)o The Hamada Equation:

Quantifies the ↑ cost of equity due to financial leverage ie. if D ↑, tell us the new cost of equity

Uses the unlevered beta – business risk of a firm if it had no debt ßL = ßU [ 1 + (1 – T)( D/E ) ] Note: ß in CAPM is ßL

o Other factors re target capital structure: Industry average debt ratio TIE ratios under different scenarios ↓ TIE, ↑ rate lender will charge Lender / rating agency attitudes Reserve borrowing capacity Effects of financing on control Asset structure ↑ intangible assets able to borrow ↓ Expected tax rate

Modigliani-Miller Irrelevance Theory:o Capital structure of a firm is irrelevant to firm’s valueo Uses many assumptions eg) shareholders have same info as managers, no bankruptcy costs, no taxes

(MM vs reality graph)o Incorporating signaling effects:

Signaling theory suggests firms should use ↓ debt than MM suggests This unused debt capacity helps avoid stock sales, which ↓ stock price because of signaling

effects If we assume:

Managers have better info than outsiders and that managers cat in best interest of stockholders, then management would:

Issue stock if they think it is overvalued Issue debt if they think stock is undervalued Hence, investors view stock offering as a negative signal empirically cause share

price to ↓ Conclusions on capital structure:

29

o Need to make calculations but only estimateso ↑ judgmental component o capital structures therefore differ widely, even within industries

Welsh: (level of detail?)o Empirically found that external stock market influences capital structure mostly (specifically, lagged

stock returns)o Concluded that managers are essentially inert ie. capital structure is imposed by external forces and

not management intervention Dividend policy:

o Decision to pay out earning vs retain and reinvesto Theories:

Dividend irrelevance: Investors don’t care about payout any OK Investors are indifferent between dividends and capital gains create their own

dividend policy ie. want cash – sell stock; no cash – use div to buy more stock Proposed by MM but on unrealistic assumptions eg) no taxes, brokerage costs

difficult to test empirically Bird-in-the-hand:

Investors prefer a high payout Investors think dividends are ↓ risky than potential capital gains like dividends ↑ payout = ↑ price

Tax preference: Investors prefer a low payout Retained earnings lead to long-term capital gains, which are taxed at ↓ rate to

dividends capital gains also deferred (therefore still preferred even if taxed equally)

↓ payout = ↑ price Note: reverse implication for cost of equity eg) tax preference > irrelevance > bird-in-the-

hand Don’t know which theory is correct manager use judgment (must apply analysis with

judgment)o Information content or signaling hypothesis:

Managers won’t ↑ dividends unless they think it is sustainable so investors view dividend ↑ as management’s view of the future

Therefore price ↑ could reflect ↑ E(EPS) not desire for ↑ dividendso Clientele effect:

Different groups of investors prefer different dividend policies Firm’s past dividend policy determines its current clientele Therefore clientele effect impedes changing dividend policy (tax, brokerage costs) change

unfavourable to existing clienteleo Residual dividend model:

Payout as dividends residual of earnings after taking out retained earnings needed for the capital budget

This minimises floatation and equity signaling costs, hence minimises WACC Dividends = Net Income – (Target equity ratio x Total capital budget) Then divide this by Net Income for ratio Implies that dividend will change every year empirically wrong Change in investment opportunities:

↓ good investment = ↓ capital budget = ↑ dividend payout

30

↑ good investment = ↓ payout Advantage – minimises frequency of new stock issues and floatation costs Disadvantages – results in variable dividends, sends conflicting signals, ↑ risk, doesn’t appeal

to any clientele Conclusion – consider residual model when setting target payout, but don’t follow rigidly

adjust slowly only if circumstances allowo Dividend reinvestment plan (DRIP):

Shareholders can reinvest dividends in shares of the company’s common stock get more stock instead of cash

Types of plans: Open market:

o Dollars to be invested are turned over to a trustee, who buys shares on the open market

o ↓ brokerage costs due to volume, convenient o Equity capital ie. no of shares, doesn’t change

New stock:o Firms issue new stock (usually at a discount), keeps money and uses it to buy

assetso Convenient way for company to expand capital base

Firms that need new equity use new stock plans Firms with no need for new equity use open market plans

o Setting dividend policy: Forecast capital needs over a planning horizons eg) 5 years Set a target capital structure Estimate annual equity needs Set target payout based on residual model Generally, some dividend growth rate emerges try to maintain this growth rate, varying

capital structure somewhat if necessaryo Stock repurchases:

Buying own stock back from shareholders Reasons:

Alternative to distributing cash as dividends allows investors to realise capital gains as opposed to dividends

To dispose of one-time cash from an asset sale To make a large capital structure change

Advantages: Stockholder can tender or not Helps avoid setting ↑ dividends that can’t be maintained Repurchased stock can be used in takeovers or resold to raise cash as needed

greenmail – reacquisition of shares from hostile bidder at a premium Income received is capital gains rather than ↑ taxed dividends Stockholders may take as positive signal – management thinks stock is undervalued

Disadvantages: May be viewed as a negative signal poor investment opportunities. Repurchase is

a zero NPV project (Σdiv = price) can signal that this is the best option available to firm (assumes however that market is efficient)

Penalties if purpose was to avoid taxes on dividends Selling stockholders may be ill-informed, hence treated harshly Firm may have to bid up prices to complete purchase, thus paying too much for its

own stock

31

Reasons for undertaking share buybacks (Lamba and Ramsay 2001): Leverage ↑ D/E ratio Information signaling might signal undervaluation Anti-takeover mechanism buyout hostile shareholders Wealth transfer more wealth to shareholders if undervalued Free cash flow cash left after all + NPV projects. Managers reluctant to give up

FCF b/c of possible wage ↑ may invest in – NPV projects instead therefore buy back positive

Earnings per share (magic?) false: assets would ↓ therefore expect earning to ↓, PE ratio would likely change more risky as ↑ D/E (can’t work, otherwise would do it to max)

Conclusions (of the article):o Share buy backs are good newso Share markets are efficient at pricing with buybacks o Buybacks signal stock is undervalued wealth transfer to those who stay

with the companyo Stock dividends and stock splits:

Stock dividend – firm issues new shares instead of cash dividend price ↑ as + signal Stock split – firm increases the number of shares outstanding no change in price Both ↑ number of shares All things remaining constant, both will cause price to ↓ to keep each investor’s wealth

unchanged Both may get stock to an ‘optimal price range’ Stock splits generally occur when management is confident, so are interpreted as positive

signals Note cum-dividend (declared but not paid) vs ex-dividend (after paid)

o Australian Tax System: Before imputation – capital gains taxed at full income rates after indexation for CPI Now (since 1999) – no indexation but tax rate is half that of income

Maximizing firm value:o Managers want to maximize share price not always the same as maximizing value of

shareholder’s investment agency issueso Determination of share price:

Expected cash flows generated by assets Timing of these cash flows earlier preferable Riskiness of cash flows

o Determination of cash flows: Investment decisions The way investments are funded debt vs equity Dividend policy

o Share price, EPS, cash flows are ↑ correlated all ↑ when sales ↑o Take care when using EPS or cash flows as an indicator of share price as also depends on

expected future earnings and cash flows

32