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Revision Notes: Book " Corporate Finance ", Chapter 1-18

Corporate Finance (Griffith University)

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Fundamnntals of Corporatn Financn – Summary

Part 1: Ovnrvinw of Corporatn Financn
Chaptnr 1: Introduction to Corporatn Financn
1.1 Corporatn Financn and thn financial Managnr
Corporate Finance: the study of ways to answer these three questions:
(1) What long-term investments?
(2) Where will you get the long-term financing to pay for your investment?
(3) How will you manage your everyday financial activities such as collecting from customers + paying suppliers?
Financial Manager: the corporation employs managers to represent the owners’ interests and make decisions on their
behalf. In a large corporation, the financial manager would be in charge of answering the three questions above
(1) Capital budgeting: process of planning + managing a firm's long-term investments, in CB the financial manager tries to
identify investment opportunities, financial managers: Evaluating the size, timing, and risk of future cash flows
(2) Capital Structure: The mixture of debt and equity maintained by a firm, ways in which the firm obtains and manages the long-
term financing it needs to support its longterm investments, fm decides for financing mix
(3) Working capital/Dividend decision: A firm’s short-term assets and liabilities, ensures that the firm has sufficient resources to
continue its operations and avoid costly interruptions, involves decision of whether to pay dividends to shareholders or maintain the
funds for internal growth, factors to consider: growth opportunities, taxation, shareholders preference
1.2 Thn Goal of Financial Managnmnnt
possible financial goals: Survive, Avoid financial distress and bankruptcy, Beat the competition, Maximize sales or market
share, Minimize costs, Maximize profits, Maintain steady earnings growth → goals refering to profitability and a way of
controlling risk, but they are all very unprecise
Goal of Financial Management: maximize current value per share of the existing stock, maximize shareholders wealth
a more general goal: maximize the market value of the existing owners’ equity
1.3 Thn Agnncy Problnm and thn Control of thn Corporation
agency problem: The possibility of conflict of interest between the stockholders (principal) and management of a firm (agent).
Agency relationships: relationship between stockholders and management, the principal (stockholder) hires an agent to represent his
interests
Management roles: agency costs refers to the costs of conflict of interest between stockholders + management,
Direct agency costs – monitoring costs, the purchase of something for management that cannot be justified from the risk-return
standpoint (e.g. purchase of a company private jet)
Indirect agency costs – management’s tendency to forgo risky or expensive projects that could be justified from a risk-return
standpoint due to fear of failure and looking bad.
Managerial compensation: Management will frequently have a significant economic incentive to increase share value
Control of the firm: stakeholders control the firm → threat of takeover and proxy fight may result in better management
control from other stakeholder: government, employees, suppliers
stakeholder: Someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm.
1.4 Financial Marknts and thn Corporation
financial market: way of bringing buyers and sellers together.
Role of a Financial Market: To channel savings into investments, Enable sale and purchase of financial assets
primary market refers to the original sale of securities by governments and corporations, corporation is the seller, and the
transaction raises money for the corporation
secondary markets: involve the continual buying and selling of issued securities, ex: New York Stock Exchange (NYSE), Tokyo
Stock Exchange (TSE) and London Stock Exchange (LSE)
Money markets: involve the trading of short-term debt securities.
Capital markets: involve the trading of long-term debt securities and shares

Chaptnr 2: Financial Statnmnnts, Taxns, and Cash Flow

2.1 Thn yalancn Shnnt
balance sheet: Financial statement/snapshot showing a firm’s accounting value (assets and liabilites) on a particular date
assets: left-hand side (current assets (CL) vs. Fixed assets (FA), tangible (PC) and intangible (patent))
liabilites and owners' equity: liabilities (current (asset) or long-term (debt → bond)) right-hand side
balance sheet identity: Assets (A) = Liabilities (L) + Stockholders’ Equity (E)
Net Working capital (NWC): Current Assets (CL) – Current Liabilities (CL) Positive (NWC>0) when the cash that will be received
over the next 12 months exceeds the cash that will be paid out → 3sually positive in a healthy firm
Liquidity: refers to the speed and ease with which an asset can be converted to cash without a significant loss in value
The more liquid a business is, the less likely it is to experience financial distress, liquid assets are generally less profitable
→ trade-off between the advantages of liquidity and forgone potential profits, liquid and illiquid assets
debt vs. Equity: use of debt in a firm’s capital structure is called financiag geverage, it increases the potential reward to
shareholders, but it also increases the potential for financial distress and business failure
market value vs. Book value: The balance sheet provides the book value of the assets, liabilities and equity, price what the firm
paid for them, no matter what they are worth today
Market value is the price at which the assets, liabilities or equity can actually be bought or sold → it is more important
2.2 Thn Incomn Statnmnnt
Income statement: Financial statement summarizing a firm’s performance over a period of time
Revenues -Expenses = Income

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Earnings per share (EPS): net income / total shares outstanding

Dividends per share (DPS): total dividends / total shares outstanding
noncash items: Expenses charged against revenues that do not directly affect cash flow, such as depreciation, reason why accounting
income differs from cash flow, time and costs: variable costs vs. Fixed costs
2.3 Cash Flow
Cash flow: one of the most important pieces of info that a financial manager can derive from financial statements
cash flow: the difference between the number of dollars that came in and the number that went out
Earnings can be easily manipulated by managers by adjusting depreciation or other items. Cash flows are more difficult to manipulate
(Cash is king).
cash flow from assets (CFA): total of cash flow to creditors and cash flow to stockholders, consisting of the following: operating cash
flow, capital spending, and change in net working capital.
Cash generated from using our assets = Cash paid to those that finance the purchase of those assets (Creditors + S)
operating cash flow (OCF): Cash generated from a firm’s normal business activities.
Cash Flow Identity: Cash Flow from Assets (CFA) = Cash Flow to Creditors (CFC) + Cash Flow to Stockholders (CFS)
CFC = Interest Paid (Cash out) – Net New Borrowings (long-term debt ending – long-term debt beginning) (Cash in)
CFS = Dividends Paid (Cash out) – Net New Equity (common shares ending – common shares beginning) (Cash in)
CFA = OCF – NCS – ΔNWC
Cash Flow From Assets (CFA) = Operating Cash Flow (OCF) – Net Capital Spending (NCS) – Changes in Net Working Capital
(ΔNWC)
OCF = EBIT + depreciation – taxes
NCS = end net fix. assets – begin net fix. assets + depr.
∆ NWC = ending NWC (CA - CL) – beginning NWC (CA-CL)
Operating cash flow: EBIT
+ Depreciation
– Taxes
Less
Net capital spending: Ending net fixed assets
– Beginning net fixed assets
+ Depreciation
Less
Change in net working capital: Ending net working capital
– Beginning net working capital
= Cash flow from assets

Part 2: Financial Statnmnnts and Long-Tnrm Financial Planning

Chaptnr 3: Working with Financial Statnmnnts
3.1 Cash Flow and Financial Statnmnnt: A closnr Look
sources of cash: A firm’s activities that generate cash.
uses of cash: A firm’s activities in which cash is spent. Also called applications of cash.
Sources: - Cash inflow – occurs when we “sell” something
- Decrease in asset account (Accounts receivable, inventory, and net fixed assets)
- Increase in liability or equity account (Accounts payable, other current liabilities, and common stock)
3ses: - Cash outflow – occurs when we “buy” something
- Increase in asset account (Accounts receivable, and other current assets)
- Decrease in liability or equity account (Notes payable and long-term debt)
Statement of cash flow: firm’s financial statement that summarizes its sources and uses of cash over a specified period.
Changes divided into three major categories:
Operating Activity – includes net income and changes in most current accounts
Investment Activity – includes changes in fixed assets
Financing Activity – includes changes in notes payable, long-term debt and equity accounts as well as dividends
Cash Flow Statement:
Operating activities: + Net profit
+ Depreciation
+ Any decrease in current assets (except cash)
+ Increase in accounts payable
– Any increase in current assets (except cash)
– Decrease in accounts payable
Investment activities: + Ending non-current assets
– Beginning non-current assets
+ Depreciation
Financing activities: – Decrease in notes payable
+ Increase in notes payable
– Decrease in long-term debt
+ Increase in long-term debt
+ Increase in ordinary shares
– Dividends paid

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CF = OCF– ΔNWC – NCS + financing

= (EBIT - tax + depr)– Δ(CA-CL) – (FA-depr) + financing
3.2 Ratio Analysis
Ratios also allow for better comparison through time or between companies, are used both internally and externally
Categories of financial rations:
- Short-term solvency or liquidity ratios
- Long-term solvency or financial leverage ratios: e.g. Total Debt Ratio, Debt/Equity Ratio, Equity Multiplier (EM) (A/E)
- Asset management or turnover ratios (Efficiency): e.g. Total Asset Turnover (TO) (Sales/A), NWC Turnover, Fixed Asset Turnover
- Profitability ratios: e.g. Profit Margin (PM) (NI/Sales), Return on Assets (ROA), Return on Equity (ROE)
- Market value ratios:
PE Ratio: Price per share / Earnings per share
Market value / Earnings
“Market-to-book” Ratio: Market price per share / Book value per share
Market value of equity / Book Value of equity
3.3 Thn Du Pont Idnntity
Du Pont identity: Popular expression breaking ROE into 3 parts: operating efficiency (as measured by profit margin PM), asset use
efficiency (as measured by total asset turnover TO), and financial leverage (as measured by the equity multiplier EM)
NI/E (ROE) = (NI/Sales) * (Sales/Asset) *(Asset/Equity)
ROE = PM * TO * EM
3.4 Using Financial Statnmnnt Information
Why evaluate financial statements?
Internal uses: Performance evaluation – compensation and comparison between divisions
Planning for the future – guide in estimating future cash flows
External uses: Creditors
Suppliers
Customers
Stockholders
Benchmarking: Ratios are not very helpful by themselves; they need to be compared to something.
Time-Trend Analysis: Used to see how the firm’s performance is changing through time
Peer Group Analysis: Compare to similar companies / industry, common way of identifying potential peers is based on
SIC codes
Standard Industrial Classification code: 3.S. government code to classify a firm by its type of business operations.
Potential Problems:
There is no underlying theory, so there is no way to know which ratios are most relevant
Benchmarking is difficult for diversified firms
Globalization + international competition makes comparison more difficult due to differences in accounting regulations
Varying accounting procedures, i.e. FIFO vs. LIFO
Different fiscal years
Extraordinary events

Part 3: Valuation of Futurn Cash Flows

Chaptnr 5: Introduction to Valuation: Thn Timn Valun of Monny
time value of money refers to the fact that a dollar in hand today is worth more than a dollar promised at some time in
the future
5.1 Futurn Valun and Compounding
future value (FV): The amount an investment is worth after one or more periods.
Compounding: The process of accumulating interest on an investment over time to earn more interest.
Simple interest: interest earned each period only on the principal
Ex. future value: you invest $1000 for one year at 5% per year future value in one year: 1000 (1+0.05) = 1050
future value in 2 years: 1000(1.05)2 = 1102.50
General Formula:FV = PV(1 + r)t , where FV = future value, PV = present value, r = pnriod interest rate, expressed as a decimal
t = number of pnriods
5.2 Prnsnnt Valun and Discounting
present value (PV): The current value of future cash flows discounted at the appropriate discount rate.
How much do I have to invest today to have some amount in the future?
FV = PV(1 + r)t → Rearrange to solve for PV = FV / (1 + r)t
discount: Calculate the present value of some future amount.
discount rate: The rate used to calculate the present value of future cash flows.
discounted cash flow (DCF) valuation: Calculating the present value of a future cash flow to determine its value today.
For a given interest rate – the longer the time period, the lower the present value
For a given time period – the higher the interest rate, the smaller the present value
To find r: rearrange to r = (FV/PV)1/t – 1
To find t: rearrange to t = LN(FV/PV)/LN(1 + r)

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Chaptnr 6: Discountnd Cash Flow Valuation

6.1 futurn and prnsnnt valuns of multipln cash flows
FV of multiple cash flows: draw a timeline at which time what sum of money is on your account and gets interest, compounding each
future value separately and adding up sum later, hoch...: Zahl der Lücken, umgekehrt Zeitstrahl
FV = C1(1+r)n-1 + C2(1+r)n-2 + …+Ct(1+r)n-t

PV of multiple cash flows: draw a timeline at which point of time you want to have how much money available, calculate the
present values individually and add them up, hoch...: Zahl am Zeitstrahl
PV = C1/(1+r) + C2/(1+r)2 + …+Ct/(1+r)t
Note: if there is an immediate cash flow (C ) at the start then begin sum with t = 0. Do not discount!!
0
6.2 valuing lnvnl cash flows: annuitins and pnrpntuitins
Annuity: finite series of equal payments that occur at regular intervals, e.g. comsumer loans → car, home mortgage
If the first payment occurs at the end of the period, it is called an ordinary annuity
If the first payment occurs at the beginning of the period, it is called an annuity due
PV=Cx {1-[1/(1+r)t]}/r
FV={[(1+r)t -1]/r}
If the monthly payments are unknown: C = PV/{[1-1/(1+r)t]/r}
to find the period it takes off to pay the amount,you need to rearrange the formula
Annuity: finding the rate → Trial and Error Process
Choose an interest rate and compute the PV of the payments based on this rate
Compare the computed PV with the actual given amount:
1.If the computed PV > given amount, then the interest rate is too low. Action: increase rate
2.If the computed PV < given amount, then the interest rate is too high. Action: lower rate
→ discount rate and present value move in opposite directions!
Adjust the rate and repeat the process until the computed PV and the given amount are equal
Suppose you begin saving for your retirement by depositing $2000 per year in an investment account. If the interest rate is 7.5%, how
much will you have in 40 years? FV = 2000(1.07540 – 1)/0.075 = 454,513.04
Perpetuity: infinite series of equal payments at regular intervals
Perpetuity: A company wants to sell preferred stock at $100 per share. Similar shares sell for $40 with $1 dividend per quarter. What
dividend will the new shares offer?
Perpetuity formula: PV = C / r, C = ?, C= P x r
Current required return: 40 = 1 / r, r = C/P,
r = 0.025 or 2.5% per quarter
6.3 comparing ratns: thn nffnct of compounding
If you want to compare two alternative investments with different compounding periods you need to compute the EAR (effective
annual rate) and use that for comparison, EAR: The interest rate expressed as if it were compounded once per year.
Nominal interest rates (NIR): This is the annual rate that is quoted by law
By definition NIR = period rate x number of periods per year
Period rate = NIR / number of periods per year
You should NEVER divide the EAR by the number of periods per year – it will NOT give you the period rate
What is the NIR if the monthly rate is 0.5%? → 0.005(12) = 6%
Formula:
m is the number of compounding periods per year
Example: Suppose you can earn 1% per month on $1 invested today.
What is the NIR ? 1% x (12) = 12%
FV = $1x(1.01)12 = $1.1268
EAR = ($1.1268 – $1) / $1 = .1268 = 12.68%
EAR = [1 + (Quoted rate/m)]m – 1 m = the number of times the interest is compounded during the year
→ If r=11% per month and is compounded, you have to divide it by 12 to get the EAR

Chaptnr 7: Intnrnst Ratns and yond Valuation

7.1 yonds and yond Valuation
What is a Bond? → Debt security
Par value (face value) = $100 → The principal that needs to be repaid
Coupon rate → Quoted rate as a percentage of face value
Coupon payment → The interest payment on a bond based on coupon rate
Maturity date → Date when principal is repaid.
Yield or Yield to maturity (YTM) → Required market rate
yond Valuation: Bond Value = Present Value of Cash Flows
Bond Value = PV of coupons + PV of par
Bond Value = PV annuity + PV single sum
Remember, as interest rates increase present values decrease → So, as interest rates increase, bond prices decrease and vice versa

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Bond value C x [1 - 1/(1 + r)t]/r + F/(1 r)t

→ bond prices and interest rates always move in opposite directions. When interest rates rise, a bond’s value, like any
other present value, will decline.
If : YTM > coupon rate then bond price < par value → Selling at a discount, called a discount bond
If: YTM < coupon rate then bond price > par value → Selling at a prnmium, called a premium bond
If: YTM = coupon rate then par value = bond price → Selling at par
Intnrnst ratn risk: possible change in bond value due to change in interest risk
1. All other things being equal, the longer the time to maturity, the greater the interest rate risk.
2. All other things being equal, the lower the coupon rate, the greater the interest rate risk.
7.2 Somn diffnrnnt typns of bonds
Difference between debt and equity:
debt: - Not an ownership interest
- Creditors do not have voting rights
- Interest is considered a cost of doing business and is tax deductible
- Creditors have legal recourse if interest or principal payments are missed
- Excess debt can lead to financial distress and bankruptcy
Equity: - Ownership interest
- Common stockholders vote for the board of directors and other issues
- Dividends are not considered a cost of doing business and are not tax deductible
- Dividends are not a liability of the firm and stockholders have no legal recourse if dividends are not paid
- An all equity firm can not go bankrupt
Types of debt in A3:
Government Securities: Treasury bonds, Treasury notes
Other Debt Securities: Bank bills, commercial bills, promissory notes, Corporate Bonds, Debentures, 3nsecured notes, Floating-rate
notes, Convertible notes, Hybrid debt securities, Collateralised Debt Obligations - CDOs
7.3 Inflation and Intnrnst Ratns
Real rate of interest – adjusted for inflation
Nominal rate of interest – quoted rate that has not been adjusted for inflation
Fisher Effect – relationship between real, nominal and inflation rate.
(1 + R) = (1 + r)(1 + h), where R = nominal rate, r = real rate, h = expected inflation rate
Approximation: R = r + h

Chaptnr 8: Stock Valuation

Issuns in sharn valuation:
If you buy a share of stock, you can receive cash in two ways: The company pays dividends, You sell your shares
As with bonds, the price of the stock is the PV of these expected cash flows, PV of all expected future dividends + PV of selling price
3ncertainty of cash flows
Indefinite life
Dividend Growth Model: A model that determines the current price of a stock as its dividend next period divided by the discount rate
less the dividend growth rate.
3 Spncial casns:Constant dividend: The firm will pay a constant dividend forever
Constant dividend growth: The firm will increase the dividend by a constant percent every period
Supernormal growth: Dividend growth is not consistent initially, but settles down to constant growth eventually

Constant (zero growth): D1 = D2 = D3.…= Dt constant dividend or zero growth

P0 = D1 / R
Ex: Suppose a stock is expected to pay the same $0.50 dividend every quarter indefinitely and the required return is 10% with
quarterly compounding. What is the price? P0 = 0.50 / (0.025) = $20

Dividend Growth Model: Dividends are expected to grow at a constant percent per period (g%)
D0 < D1 < D2 …Dt-1< Dt P0 = D1/(r-g) = Do(1+g)/(r-g), Pt=Dt(1+g)/r-g = Dt+1/r-g
Beispiel: P4=D5(1+g)/r-g, D5=D1(1+g)4
dividend's yield: A stock’s expected cash dividend divided by its current price.

Chaptnr 9: Nnt Prnsnnt Valun and othnr invnstmnnt critnria

Good Dncision Critnria:
We need to ask ourselves the following questions when evaluating capital budgeting decision rules
- Does the decision rule adjust for the time value of money?
- Does the decision rule adjust for risk?
- Does the decision rule provide information on whether we are creating value for the firm?

Nnt prnsnnt valun (NPV)

Difference between market value and cost
Take the project if the NPV is positive, if not reject it

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Has no serious problems

Preferred decision criterion

Intnrnal ratn of rnturn (IRR)

Discount rate that makes NPV of an investment = 0, calculation with NPV formula and trial and error process
Take the project if the IRR is greater than the required return
most important alternative after NPV, often used in practice
Same decision as NPV with conventional cash flows, but:
IRR is unreliable with non-conventional cash flows or mutually exclusive projects (you can only choose one project)

Prnsnnt Valun Indnx (PVI)

Benefit-cost ratio, Measures the benefit per unit of cost, based on the time value of money
Calculation: PVI = PV of CF/Cost
Take investment if PI > 1
Cons: Cannot be used to rank mutually exclusive projects
Pros: closely related to NPV and leading to same decision, easy to understand, useful if investment funds are limited

Discountnd payback pnriod

Length of time until initial investment is recovered on a discounted basis
calculation: Compute PV of each cash flow, Subtract the discounted cash flows from initial cost, Compare to specified required period
Take the project if it pays back in some specified period
Cons: arbitrary cutoff period, may reject positive NPV projects, ignores cash flows beyond cutoff date, biased against longterm
projects
Pros: includes time value of money, easy to understand, biased towards liquidity, does not accept negative estimated NPVs

Payback pnriod
Length of time until initial investment is recovered
Computation: Estimate cash flows, Subtract the future cash flows from the initial cost until the initial investment has been recovered
calculate last postive cashflow : number which is still to cover to receive exact time
Take the project if it pays back in some specified period
Cons: Doesn’t account for time value of money, arbitrary cutoff period, ignores cash flows beyond cutoff date, biased against
longterm projects
Pros: easy to understand, biased towards liquidity

Chaptnr 12: Somn Lnssons from Capital Marknt History

the greater the risk, the greater the required return → there is a reward for bearing risk, the greater the potential reward is, the
greater
is the risk
Rnturns
Dollar Return: the sum of the cash received and the change in value of the asset in dollars
Return on investment: 1) income component (e.g. dividends) 2) change of value of the asset (capital gain or loss)
Total dollar return: Dividend income + Capital gain (or loss)
Total cash if stock is sold: Initial investment + Total return
Percentage Returns: the cash received and the change in value
of the asset divided by the original investment.
Dividend yield Dt +1/Pt
Capitag gains yiegd (P t +1 - Pt)/Pt
Holding Period Returns:
the return that an investor would get when holding an investment
over a period of n years

Avnragn Rnturns
Gnomntric Avnragn = annual average compound return per period over multiple periods, is overly pessimistic for short horizons - use
over long term GM =Rg = π[1+R]1/t -1 → Rg =[(1+R1)x(1+R2)x(1+R3)x(1+R4)]1/t -1
Arithmntic Avnragn = return in an average year per period over multiple periods,
is overly optimistic for long horizons - use over short term AM= Ra

Risk Mnasurnmnnts:
Main Measures:
- Variance (VAR): = the average of the squared differences between the actual return and the average return.

- Standard Deviation (SD): = square root of Variance

Lnssons from Capital Marknt History

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- Data reflects two features often observed in financial markets: - There is a reward for bearing risk.
- The larger the potential reward, the larger the risk.
- This is called the risk-return trade-off
- There is a positive relationship between risk and return
Risk Prnmium
- The “extra” return earned for taking on risk
- The risk premium is the return over and above the risk-free rate
- Average Return – Risk-free Rate = Risk Premium
- What is a risk free rate? Treasury bills are considered to be risk-free. Can use Government bonds as well, Considered risk free in
terms of ability of pay interest obligations

Capital Marknt Efficinncy

Efficient Capital Markets: A market in which security prices reflect available information → based on available information, there
is no reason to believe that the current price is too low or too high.
efficient markets hypothesis (EMH): The hypothesis that actual capital markets, such as the NYSE, are efficient.
It means that, on average, you will earn a return that is appropriate for the risk undertaken and there is not a bias in prices that can be
exploited to earn excess returns
3 forms:
- weak form efficiency: - Prices reflect all past market information such as price and volume
- investors cannot earn abnormal returns by trading on market information
- Implies that technical analysis will not lead to abnormal returns
- Empirical evidence indicates that markets are generally weak form efficient
- semistrong form efficiency: - Prices reflect all publicly available information including trading information, annual reports,
press releases, etc.
- investors cannot earn abnormal returns by trading on public information
- Implies that fundamental analysis will not lead to abnormal returns
- strong form efficiency: - Prices reflect all information, including public and private
- investors could not earn abnormal returns regardless of the information they possessed
- Empirical evidence indicates that markets are NOT strong form efficient and that insiders could earn
abnormal returns

Chaptnr 13: Rnturn, Risk and Sncurity Marknt Linn

Expnctnd Rnturns
Average or Expected returns is based on the average of all possible future returns weighted by their probabilities,
Suppose there are T possible returns, and that R1 has probability p1 of occurring, R2 has probability p2 , …, and RT has probability
pT . Then: Expected returns = Sum of returns x possibility

Variancn and Standard Dnviation

measure the volatility of returns
3sing unequal probabilities for the entire range of possibilities
Weighted average of squared deviations from the expected returns

Portfolio = a collection of assets

An asset’s risk and return are important in how they affect the risk and return of the portfolio
The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation, like individual assets
portfolio weight: A percentage of a portfolio’s total value that is in a particular asset.
Portfolio expected returns:
Method 1: weighted average of the expected returns for each asset in the portfolio
Step 1: calculate expected return of the individual assets
Step2: calculate expected return based on weights of assets
Method 2: finding the portfolio return in each possible state and computing the expected value as we did with individual securities
Step 1: calculate expected return in each state, e,g, boom or recession
Step 2: add the state returns weighted by each probability
Portfolio Variance with probabilities: careful! not generally a simple combination of the variances of the assets in the
portfolio!!
combining assets into portfolios can substantially alter the risks faced by the investor!!
1) Compute the portfolio return for each state, boom, bust.. etc. (step 1): E(RPstate) = w1R1 + w2R2

2) Compute the E(Rpstate) using probabilities as for a single asset: E(RP) = p1 x E(Rstate1) + p2 x E(Rstate2) + p3 x E(Rstate3)

3) This E(RP) becomes the mean

4) Compute the deviations of each state from the mean, then square the deviation: [E(RPstate)-E(RP)]2

5) Multiply the squared deviation with probability of each state, then sum: ∑ (pstate x [E(RPstate)-E(RP)]2)
Total return = expected return + unexpected return, on average the expected return equals the actual return

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Risk and Portfolio Theory: Risk Averse Investors: require a higher average return to take on a higher risk
Portfolio Theory Assumption: Investors prefer the portfolio with the highest expected return for a given variance, or, the lowest
variance for a given expected return
Expected returns and Variances of Portfolios derived from historical returns, variances, and covariances of individual assets in
portfolio

Covariancn and Corrnlation Confficinnt

Covariance is an absolute measure of the degree to which two variables move together over time relative to their individual mean.
Correlation Coefficient, ρ, is a standardised measure of the relationship between the two variables, ranging between -1.00 to +1.00
In order to reduce the overall risk, it is best to have assets with low positive or negative correlation (covariance)
The smaller the covariance between the assets, the smaller will be the portfolio’s variance
Systnmatic or unsystnmatic Risk
Systematic or Non-Diversifiable Risk, market risk: That portion of an asset’s risk attributed to the market factors that affect all firms
and cannot be eliminated through the process of diversification.
3nsystematic or Diversifiable Risk asset-specific risk: That portion of an asset’s risk which is firm specific and can be eliminated
through the process of diversification
Total risk = systematic risk + unsystematic risk
The standard deviation of returns is a measure of total risk
For well-diversified portfolios, unsystematic risk is very small → essentially equivalent to the systematic risk
Thn Principln of Divnrsification:
states that spreading an investment across many assets will eliminate some but not all of the risk.
Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns
Size of risk reduction depends on covariances between assets in the portfolio
However, there is a minimum level of risk that cannot be diversified away and that is the systematic portion
3nsystematic risk is essentially eliminated by diversification, but systematic risk cannot be reduced by a portfolio
Systnmatic Risk and ynta
Systematic Risk Principle: There is a reward for bearing risk
There is not a reward for bearing risk unnecessarily
The expected return on a risky asset depends only on that asset’s systematic risk since unsystematic risk can be diversified away
risk premium only depends on systematic risk
Mnsuring systnmatic risk = ß:
We use the beta coefficient to measure systematic risk
Beta measures the responsiveness of a security to movements in the market.
beta coefficient: The amount of systematic risk present in a particular risky asset relative to that in an average risky asset.
Market beta βm = 1
Therefore if: βA= 1, the asset has the same systematic risk as the overall market
βA < 1 implies the asset has less systematic risk than the overall market
βA > 1 implies the asset has more systematic risk than the overall market
Because assets with larger betas have greater systematic risks, they will have greater expected returns → risk premium
A portfolio beta can be calculated, just like a portfolio expected return
Thn capital assnt pricing modnl (CAPM)
- defines the relationship between risk and return
- If we know an asset’s systematic risk, we can use the CAPM
to determine its expected return
- This is true whether we are talking about financial assets or
physical assets
shows that expected return of a particular asset depends on 3 things:
- time value of money
- reward for bearing systematic risk
- amount of systematic risk
Thn Sncurity Marknt Linn
= is the graphical representation of CAPM
Shows the relationship between systematic
risk and expected return
Positive slope
The higher the risk, the higher the return
According to the CAPM, all stocks must
lie on the SML, otherwise they would be
under or over-priced.
Reward to risk Ratio:
SML slope = Reward to Risk Ratio of Market
= Market Risk Premium

In equilibrium, all assets and portfolios must

have the same reward-to-risk ratio and they
all must equal the reward-to risk ratio for the
market, If not, assets are undervalued or
overvalued
Chaptnr 15: Thn Cost of Capital

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Our cost of capital provides us with an indication of how the market views the risk of our assets
Rnquirnd rnturn = cost of capital
- The Required Rate of Return = Discount Rate = Hurdle Rate = Cost of Capital
- Need to know the required return for an investment so we can compute the NPV and decide whether or not to take the investment
- Need to earn at least the required return to compensate investors for their financing
- Required return – from the investor’s point of view
- Cost of capital – from the firm’s point of view
Cost of Capital
- Cost of Capital is a mix of Cost of Equity and Cost of Debt
- These costs are determined by the market
- The firm determines the mix, Debt/Equity (D/E) reflecting it’s target capital structure.
- To calculate cost of capital: Calculate cost of equity → Calculate cost of debt → Combine them
Cost of Equity
- The cost of equity is the return required by equity investors, the shareholders on their investment in the firm
- Since this cost is not directly observable, it must be estimated
- There are two main methods for determining the cost of equity: - Dividend Growth Model
- CAPM
DGM Approach
Start with the dividend growth model formula where g is constant:
Where: RE is the required return for shareholders, P0 is the current price, D0 is the current/last dividend, D1 is the next dividend.
Rearranging to solve for RE:
Where D1/P0 is the dividend yield, and g is the growth rate of dividends
Problem: estimate the dividend growth rate: e.g. through historical average or using analysts forecast
Advantages and Disadvantages of DGM:
- Advantage: Easy to understand and use
- Disadvantages: Only applicable to companies currently paying dividends, Assumes dividend growth is constant, Cost of equity is
sensitive to growth estimate, Does not explicitly consider risk
CAPM Approach
using the SML approach, the expected return of the asset i is: , rearranging for return expected we
get:
Advantages and disadvantages of CAPM:
- Advantages: Explicitly adjusts for risk, Applicable to all companies
- Disadvantages: Have to estimate the expected market risk premium, which does vary over time, Have to estimate beta, which also
varies over time, We are using the past to predict the future, which is not always reliable
Cost of Prnfnrrnd Stock
- Preferred stock pays a constant dividend
- Dividends are expected to be paid forever
- Preferred stock return = Perpetuity RP P0 = D/Rp → RP = D / P0

Cost of Dnbt
The cost of debt is the required return on our company’s debt
We usually focus on the cost of long-term debt or bonds
The required return is best estimated by computing the yield-to-maturity or YTM
The cost of debt is NOT the coupon rate
For publicly listed debt use YTM
If the firm has no publicly traded debt, use YTM on similar debt that is traded

→ solve after RD with a trial and error process

Wnightnd avnragn cost of capital

We can use the individual costs of capital that we have computed to get our “average” cost of capital for the firm.
WACC is the required return on our assets, based on the market’s perception of the risk of those assets
The weights are determined by how much of each type of financing we use: WACC = wE*RE + wP*RP + wD*RD
E = market value of equity = nr. of outstanding shares times price per share
P = market value of preference shares = nr. of outstanding preference shares times price per share
D = market value of debt = nr. of outstanding bonds times bond price
V = market value of the firm = E + P + D
Weights: wE = E/V = percent financed with equity
wP = P/V = percent financed with preference stock
wD = D/V = percent financed with debt
wE + wP + wD = 1
WACC adjustnd
The company gets a tax deduction for interest on debt, reducing the effective cost of debt.
If TC is the corporate tax rate then the after tax cost of debt is RD*(1  TC), and the WACC adjusted for taxation effects is given by:
WACC = wE*RE + wP*RPS + wD*RD*(1  TC) or WACC = (E/V)*RE + (P/V)*RPS +(D/V)*RD*(1  TC)
WACC interpretation: it is the overall return the firm must earn on its existing assets to maintain the value of its stock.
To calculate the WACC:
Step 1: Calculate cost of equity and cost of debt

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Step 2: Calculate the market value of each source of financing and the weights
Step 3: Calculate the WACC adjusting for tax
to find the numbers of an D/E taio = 0.33 just assign one number (e.g. 1) to E, afterwards calculate D=0.33v and V=1.33, afterwards
you can calculate the E/v and D/V for the WACC
WACC can be taken into account to see if a firm should take on a porject or rather not or as a performance evaluation
Divisional and Projnct Costs of Capital
- 3sing the WACC as our discount rate is only appropriate for projects that have the same risk as the firm’s current operations
- If we are looking at a project that does NOT have the same risk as the firm, then we need to determine the appropriate discount rate
for that project
- Divisions also often require separate discount rates
danger: a firm that uses its WACC to evaluate all projects will have a tendency to both accept unprofitable investments and
become increasingly risky.
Othnr approachns to estimating a discount rate:
- divisional cost of capital—used if a company has more than one division with different levels of risk;
- pure play approach —a discount rate that is unique to a particular project is used;
Look at companies in the same line of business as the new project
Calculate an average WACC for all the companies and use this rate as the discount rate of the new project
- subjective approach —projects are allocated to specific risk classes which, in turn, have specified discount rates
Consider the project’s risk relative to the firm overall risk
If the project risk > firm risk, use a discount rate > WACC
If the project risk < firm risk, use a discount rate < WACC
Flotation Costs
The required return depends on the risk, not how the money is raised
However, the cost of issuing new securities should not just be ignored either
Basic Approach: Compute the weighted average flotation cost, 3se the target weights because the firm will issue securities in these
percentages over the long term fA = (E/V)*fE + (D/V)* fD, where fA is the weighted average flotation cost, fE is the equity flotation
cost proportion, and fD is debt flotation cost proportion.
True cost of project = Cost/(1-fA)

Chaptnr 17: Financial Lnvnragn and Capital Structurn Policy

Choosing the capital structure: What is the primary goal of financial managers?
Maximize stockholder wealth → Choose the optimal capital structure → Maximize the value of the firm → Minimize the WACC

Thn Effnct of Financial Lnvnragn

Capital Rnstucturing: - Financial leverage = the extent to which a firm relies on debt financing
- Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets
- The firm can increase leverage by issuing debt and repurchasing outstanding shares
- The firm can decrease leverage by issuing new shares and retiring outstanding debt
Thn Effnct of Lnvnrage: How does leverage affect the EPS and ROE of a firm?
- More debt financing, means more fixed interest expense
- In expansion, we have more income after we pay interest, have more left over for stockholders
- In recession, we still have to pay our costs therefore we have less left over for stockholders
- Leverage amplifies the variation in both EPS and ROE
- If EBIT is above break-even-point, leverage is beneficial;
Break-even-EBIT: Break-Even EBIT where: EPS debt = EPS no debt
If expected EBIT > break-even EBIT, then leverage is beneficial to our stockholders
If expected EBIT < break-even EBIT, then leverage is detrimental to our stockholders

Capital Strucutre Theory

Modigliani and Miller Theory of Capital Structure
Proposition I – firm value
Proposition II – cost of equity & WACC
The value of the firm is determined by the cash flows to the firm and the risk of the assets
Changing firm value: Change the risk of the cash flows, Change the cash flows
3 special cases: (1) Case I – Assumptions: No taxes, No bankruptcy costs
(2) Case II – Assumptions: With taxes, No bankruptcy costs
(3) Case III – Assumptions: With taxes, With bankruptcy costs
Casn 1: Proposition I: The value of the firm is NOT affected by changes in the capital structure
The cash flows of the firm do not change; therefore, value doesn’t change
Proposition II: Cost of Equity increases as Debt increases
The WACC of the firm is NOT affected by capital structure
WACC = RA = (E/V)RE + (D/V)RD
RE = RA + (RA – RD)(D/E)

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RA is the “cost” of the firm’s business risk, i.e., the risk of the firm’s assets
(RA – RD)(D/E) is the “cost” of the firm’s financial risk, i.e., the additional return required by stockholders to compensate for the risk
of leverage

CAPM, yusinnss Risk, Financial Risk and Proposition II

How does financial leverage affect systematic risk?
CAPM: RE = Rf + E(RM – Rf) for equity CAPM: RA = Rf + A(RM – Rf) for assets
Where   A is the firm’s asset beta and measures the systematic risk of the firm’s assets, also called unleverred beta – the risk of the
assets if the firm would have no debt ( in essence E = A if no debt)
RE = RA + (RA – RD)(D/E)
RE = RA + (RA – Rf)(D/E) assume RD = Rf
Proposition II
As we introduce debt in the firm:
RE = Rf + A(1+D/E)(RM – Rf)
E = A(1 + D/E)
Therefore, the systematic risk of the stock depends on: Systematic risk of the assets, A, (Business risk)
Level of leverage, D/E, (Financial risk)
→ as the firm raises its debt-equity ratio, the increase in leverage raises the risk of the equity and therefore the required
return or cost of equity
→ The total systematic risk of the firm’s equity thus has two parts: business risk (not affected by capital strucutre) and
financial risk (affected by capital strucutre)

Pizza Analogy and Capital Strucutre Theory

Assuming pereect capital markets, M&M found, without taxes, the total value of a firm is unaffected by its capital structure
Whether or not an investment makes sense does not depend on how we are going to raise the money to pay for it
→ A firm's cash flow is like a pizza: to change the firm's capital structure is to change the size of individual pizza slices
This dons not changn thn ovnrall sizn of thn pizza, nor does it change the overall value of the firm

Casn 2: Introducing Taxns

What happens to the firm’s cash flows? Interest is tax deductible → when a firm adds debt, it reduces taxes, all else equal
The reduction in taxes increases the cash flow of the firm
How should an increase in cash flows affect the value of the firm?
Tax savings = TC + RD * D
Casn 2 with taxns, Proposition I
The value of the firm increases by the present value of the annual interest tax shield
Value of a levered firm = value of an unlevered firm + PV of interest tax shield
Assuming perpetual cash flows: VU = EyIT(1-T) / RU with no debt R3 = RA= RE and V3 = E
VL = VU + D*TC E = VL – D

Casn 2 with taxns, Propostition II

When taxes are introduced in Case II:
RE increases as Debt increases: RE = RU + (RU – RD)(D/E)(1-TC)
WACC decreases as D/E increases: RL = WACC = (E/V)RE + (D/V)(RD)(1-TC)
Casn 3: with yankruptcy costs
As the D/E ratio increases, the probability of bankruptcy increases
This increased probability will increase the expected bankruptcy costs
At some point, the additional value of the interest tax shield will be offset by the increase in expected bankruptcy cost
At this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added
Bankruptcy Costs:
– Direct costs: Legal and administrative costs
– Indirect costs: Larger than direct costs & more difficult to measure and estimate
– Financial distress costs: All costs associated with going bankrupt and/or avoiding bankruptcy (direct + indirect costs)

Optimal Capital strucutrn

A firm will borrow because the interest tax shield is valuable. At relatively low debt levels, the probability of bankruptcy and
financial distress is low, and the benefit from debt outweighs the cost. At very high debt levels, the possibility of financial
distress is a chronic, ongoing problem for the firm, so the benefit from debt financing may be more than offset by the
financial distress costs → an optimal capital structure exists somewhere in between these extremes.

Conclusions:
- Case I – no taxes or bankruptcy
costs: No optimal capital structure

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- Case II – corporate taxes but no

bankruptcy costs, Optimal capital
structure is almost 100% debt, Each
additional dollar of debt increases
the cash flow of the firm

- Case III – corporate taxes and

bankruptcy costs, Optimal capital
structure is part debt and part equity,
Occurs where the benefit from an
additional dollar of debt just offsets
the increase in expected bankruptcy
costs

Managnrial Rncommnndations
- The tax benefit is only important if the firm has a large tax
liability
- Risk of financial distress:
The greater the risk of financial distress, the less debt will
be optimal for the firm
The cost of financial distress varies across firms and
industries and as a manager you need to understand the cost
for your industry

Chaptnr 18: Dividnnds and Dividnnd Policy

Cash Dividnnds
- Regular cash dividend: cash payments made directly to stockholders, usually each quarter
- Extra cash dividend: indication that the “extra” amount may not be repeated in the future
- Special cash dividend: similar to extra dividend, but definitely won’t be repeated
- Liquidating dividend: some or all of the business has been sold
Dividnnd Paymnnt Chronology
- Declaration Date : Board declares the dividend and it becomes a liability of the firm
- Ex-dividend Date: 7 business days before date of record, Stock bought on or after this date, will not receive the dividend, Stock
price generally drops by about the amount of the dividend
- Date of Record : Holders of record are determined
- Date of Payment : Cheques are mailed

Dons Dividnnd Policy mattnr?

- Dividends matter!!!!!
the value of the stock is based on the present value of expected future dividends
- Dividend policy may not matter
Pay larger dividends and reinvest less vs
Pay smaller dividends and retain funds to reinvest more in the firm
In theory, if the firm reinvests capital now, it will grow and can pay higher dividends in the future
Irrnlnvancn Thnory
Modigliani and Miller’s (1961) irrelevance theory makes use of home-made dividends and relies on a number of assumptions:
– No company taxes, no transaction costs or market imperfections.
– No personal taxes
– A fixed capital budgeting program
The value of a firm:
– is determined by the earning power of the firm’s assets
– is not affected how the income is split between dividends and retained earnings.
Homnmadn Dividnnd Policy
Investors will not pay higher prices for firms with higher dividend payouts.
In other words, dividend policy will have no impact on the value of the firm because investors can create whatever income stream
they prefer by using homemade dividends.
Homemade Dividend Policy = Tailored dividend policy created by individual investors to undo corporate dividend policy
Rnlnvancy of dividnnd policy: 2 contradictory vinws:
- Dividend Policy is irrelevant → Since investors do not need dividends to convert shares to cash, dividend policy will have no impact
on the value of the firm
– Dividend policy is relevant → investors prefer high dividend policy because dividends are cash, and so are less risky than
capital gains that depend on future market sentiment., Differential tax treatment for dividends and capital gains can either favour or
penalise a dividend policy

Rnal-World Factors Favoring a Low Payout

Why might a low payout be desirable?

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- Taxes: Individuals in upper income tax brackets might prefer lower dividend payouts, given the immediate tax liability, in favor of
higher capital gains with the deferred tax liability. All other things being the same, when personal tax rates are higher than
corporate tax rates, a firm will have an incentive to reduce dividend payouts. However, if personal tax rates are lower than
corporate tax rates, a
firm will have an incentive to pay out any excess cash in dividends.
- Flotation costs (for selling stock) – low payouts can decrease the amount of capital that needs to be raised, thereby lowering flotation
costs
- Dividend restrictions – debt contracts might limit the percentage of income that can be paid out as dividends
Thn imputation Systnm
The imputation system results in shareholders receiving a tax credit with their dividend for the tax actually paid by the company.
Imputation credits can be offset against income tax on the income of shareholders.
Franked dividends are dividends that are paid out of company profits on which tax has been levied.
Dividends are declared as: - eully eranked
- partially eranked
- uneranked

Rnal-World Factors Favoring a High Payout

Why might a high payout be desirable?
- Desire for current income: Individuals that need current income, i.e. Retirees, Groups that are prohibited from spending principal
(trusts and endowments)
- 3ncertainty resolution – no guarantee that the higher future dividends will materialize
- Taxes: Dividend income taxed less for corporation shareholders, Tax-exempt investors don’t have to worry about differential
treatment between dividends and capital gains

A Rnsolution of Rnal-World Factors?

Dividnnds and Signals
Asymmetric information – managers have more information about the health of the company than investors
Information Content Effect > Changes in dividends convey information > Cause market reaction
- Dividend increases: Management believes it can be sustained, Expectation of higher future dividends, increasing present value,
Signal of a healthy, growing firm
– Dividend decreases: Management believes it can no longer sustain the current level of dividends, Expectation of lower
dividends indefinitely; decreasing present value, Signal of a firm that is having financial difficulties
Clinntnln Effnct
Some investors prefer low dividend payouts and will buy stock in those companies that offer low dividend payouts
Some investors prefer high dividend payouts and will buy stock in those companies that offer high dividend payouts
→ If a firms changes the dividend policy from low to high or vice versa, it doesn’t matter!!

Establishing a Dividnnd Policy

Rnsidual dividnnd policy
Determine capital budget
Determine target capital structure
Finance investments with a combination of debt and equity in line with the target capital structure: Remember that retained earnings
are equity, If additional equity is needed, issue new shares
If there are excess earnings, then pay the remainder out in dividends
Constant growth dividnnd policy – dividends increased at a constant rate each year
Strict Residual Policy may lead to very unstable dividend payout : Depends on profitable investment opportunities
When earnings are seasonal, quarterly dividends can vary: Eg. Department stores before/after Christmas
Stable dividend policy is in the interest of the firm and its shareholders: Decrease uncertainty of future dividends
Constant payout ratio – pay a constant pnrcnnt of narnings nach ynar
Compromisn dividnnd policy
- Goals, ranked in order of importance:
Avoid cutting back on positive NPV projects to pay a dividend
Avoid dividend cuts
Avoid the need to sell equity
Maintain a target debt/equity ratio
Maintain a target dividend payout ratio
- Companies want to accept positive NPV projects, while avoiding negative signals
Dividnnd Rninvnstmnnt Plans – DRPs
Cash dividends are used to buy additional newly issued shares in the company
Advantages to the Company: - cheap and effective means of raising capital and conserving cash
- promotes good shareholder relations
Disadvantages to the company: - administration costs
- promotion of the plan
- may lead to excessive capital raising
Benefits to Investors - taxation benefits
- flexibility
- savings program

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- no transaction costs involved

- sometimes offered at a discount
Disadvantages to investors - non-participants get diluted when participants get new shares at a discount.
- comprehensive records to be maintained
- no control over the reinvestment price

Stock Rnpurchasn
- Company buys back its own shares of stock: Equal access purchase, On-market purchase, Employee share purchase, Selective
purchase, Odd-lot purchase
- Similar to a cash dividend in that it returns cash from the firm to the stockholders
- Supports the argument for dividend policy irrelevance in the absence of taxes or other imperfections
- In a world with taxes, repurchases may be more desirable due to the options provided to stockholders

Stock Dividnnds
- Pay additional shares of stock instead of cash
- Increases the number of outstanding shares
- Small stock dividend – less than 20 to 25%
- Large stock dividend – more than 20 to 25%
Stock Splits
Stock splits – essentially the same as a stock dividend except expressed as a ratio
Stock price is reduced when the stock splits
If have 100 shares @ $30 each
A 2 for 1 stock split is the same as a 100% stock div.
New nr of shares = old nr. x (new nr./old nr.) = 200
New price = old $ x (old/ new) = $15
Common explanation for split is to return price to a “more desirable trading range”
Reverse split – number of share is reduced
If same data and have a 1 for 2 reverse split:
New nr of shares = old nr. x (new nr./old nr) = 50
New price = old $ x (old/ new) = $60

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